Welcome to our explanation of Automatic Market Makers, or AMMs. AMMs are revolutionary protocols in decentralized finance that replace traditional order book systems with mathematical formulas. Instead of matching buyers and sellers directly, AMMs use liquidity pools to facilitate trades automatically.
Liquidity pools are the heart of AMMs. They contain pairs of tokens, like ETH and USDC, in specific ratios. Users called liquidity providers deposit equal values of both tokens into the pool. In return, they receive a share of the trading fees generated when others trade using the pool.
The constant product formula x times y equals k is the mathematical foundation of AMMs. Here, x represents the quantity of token A, y represents the quantity of token B, and k is a constant. When someone buys token A, the quantity x decreases, so y must increase to maintain the constant k, which automatically increases the price of token A.
Let's see how trading works in an AMM. A trader wants to swap 10 ETH for USDC. They send their ETH directly to the liquidity pool. The AMM's formula calculates how much USDC they receive based on the current pool ratio. As ETH is added to the pool, its price increases, and the trader receives fewer USDC per ETH than the initial rate.
AMMs offer several key advantages over traditional exchanges. They operate 24/7 without human intervention, provide global access to anyone with a crypto wallet, eliminate the need for intermediaries, and allow users to earn passive income by providing liquidity. These benefits make AMMs a cornerstone of decentralized finance, revolutionizing how we think about trading and market making.