Automated market makers, also known as AMMs, are decentralized exchanges where users can trade with a smart contract.

Automated market makers have several different trading pairs, just like the ones one can find in a normal exchange, but they rely on mathematical formulas for token pricing and smart contracts acting as the makers in exchange transactions.

It is a very close concept to established quick-swap services but with liquidity pools instead of a company’s reserves being used.

Liquidity pools will contain two assets in a trading pair and the relative percentage of each token will determine the price of any particular asset.

Automated Market Makers Explained

The reason behind these exchanges’ existence is simple: to provide liquidity in a much simpler and cheaper fashion.

AMMs work around their blockchain’s performance restrictions as came about as a solution to other decentralized exchanges which used the standard order book but suffered from liquidity issues.

As these exchanges were built on Ethereum, that led to the blockchain being completely overwhelmed by orders. As such, problems kept arising for both the liquidity providers as well as for market makers. The constant readjustment necessity of buy and sell orders would cost money and time and Automated Market Makers provided a completely automated solution.

How are Smart Contracts able to automate trading?

It is important to understand that Automated Market Maker’s users are interacting directly with the liquidity pool. As such, their very own tokens are sent there and, by process of a mathematical formula, it is decided how many tokens of the other side of the selected pair they will be able to get in return.

As such, each trade will inherently have a small amount of slippage on small orders and a large amount on large ones.