Automated Market Maker (AMM)

An automated market maker replaces the order book with a pool of two or more tokens and a pricing rule. The most common rule, popularized by Uniswap, is the constant product formula x times y equals k. The product of the two token balances must stay the same after every trade, so buying one token from the pool raises its price smoothly as its balance falls.

Example: a pool holds 10 ETH and 20,000 USDC, so k is 200,000 and the implied price is 2,000 USDC per ETH. A trader who adds 2,000 USDC to the pool can take out enough ETH to keep the product at 200,000: the pool now holds 22,000 USDC, so ETH must fall to about 9.09, meaning the trader receives about 0.91 ETH. The price they paid was about 2,200 USDC per ETH, higher than the quoted 2,000 because of slippage.

Anyone can supply tokens to the pool and earn a share of trading fees in return. This lets a DEX offer markets for thousands of tokens without professional market makers. The cost to liquidity providers is impermanent loss, which occurs when the two tokens' prices diverge.