Some of the people who engage in trading on the market prefer the elimination of the need for trust and a central authority. In the traditional method, trading transactions are recorded in order books. Automated market makers, on the other hand, work with smart contracts and aim to meet the needs of those who engage in trading transactions.

An automated market maker is a system that automatically manages buy and sell data on the order book using formulas. It is also defined as a decentralized system in which trading transactions are automatically carried out with mathematical equations.

The automated market maker provides market liquidity through automatic buying and selling and eliminates the need for market-making techniques. The AMM is a concept that emerged with DeFi (Decentralized Finance) technology. It is also a financial instrument specific to Ethereum and DeFi. The AMM is an autonomous trading protocol that impacts decentralized cryptocurrency exchanges (DEX).

How Does Automated Market Maker Work?

Automated market maker eliminates intermediaries and operates with an AMM liquidity pool, algorithm, and smart contract. The AMM minimizes manual intervention, delays, manipulation, and slippage.

In an AMM mechanism, anyone can become a liquidity provider as long as the requirements specified in the smart contract are met. The liquidity provider can earn income with their contributions to the liquidity pool and can automatically provide trading transactions.

The automated market maker relies on the liquidity ratio contributed to the pools to execute trading transactions provided by smart contracts. Users can exchange their cryptocurrencies in the pool as they wish. The AMM, which operates with mathematical formulas, prevents major fluctuations in prices. The pricing algorithm also consists of a formula.

How Does Pricing Formula Work?

The most common pricing formula is x * y = k.

• k is the fixed liquidity amount,
• x is the amount of the first asset in the liquidity pool,
• y is the amount of the second asset in the liquidity pool.

If the value of y increases, the value of x will decrease to help keep k constant.

What Are the Advantages of Automated Market Maker?

In AMM, direct exchange between individuals is not necessary for transactions to occur, thus providing stability for users. Users can directly trade from the liquidity pool without waiting for a different transaction to occur.

AMM simplifies decentralized transactions on the blockchain network, providing clarity and transparency for every automatic transaction. Users who conduct transactions can control their cryptocurrencies. AMMs allow for trading in the DEX ecosystem without requiring setup or verification.

Finally, automated market makers help price cryptocurrencies in a neutral and stable manner because they operate on a pricing algorithm.

What Is Liquidity Pool?

Liquidity pool is the locking of cryptocurrencies with smart contracts. It works to solve the liquidity problem in decentralized cryptocurrency platforms and enables liquidity providers to earn additional profits. Automated market maker is one of the fundamental components of the liquidity pool. It serves to facilitate the trading of cryptocurrencies in the liquidity pool.

What Is the Relation Between Automated Market Makers and Liquidity Providers?

Liquidity providers enable the existence of liquidity pools and add cryptocurrencies to these pools. In decentralized finance ecosystems, every user can become a liquidity provider through smart contracts, and the goal of these providers is to make profits from these assets.

Unfunded pools have a high potential for slippage, and to reduce this risk, automated market makers encourage users to deposit cryptocurrencies into the pools. Automated market makers require liquidity to function, and liquidity providers enable the operation of AMMs.

What Is an Impermanent Loss?

Impermanent loss is the change in value of a locked cryptocurrency during the locking process when liquidity is provided to the liquidity pool. The higher the change in the value ratio of the asset, the higher the impermanent loss. Therefore, automated market makers work with cryptocurrencies that have similar values. Liquidity providers suffer losses when there is fluctuation in the value ratio of the cryptocurrency in the pool. However, if a liquidity provider withdraws their asset from the pool, the loss becomes permanent.

What Are the Advantages of Automated Market Makers in the DeFi Ecosystem?

• Automated market makers enable users to trade their cryptocurrencies without needing an intermediary.
• The fact that automated market makers are completely automated eliminates concerns about manual order book methods for users.
• Automated market makers keep costs to a minimum and offer low fees to traders.
• Automated market makers provide more liquidity to traders.

What Are the Disadvantages of Automated Market Makers in the DeFi Ecosystem?

• Automated market makers depend on price slippage and impermanent loss.
• Due to being fully automatic, automated market makers may be vulnerable to fraud and computer hackers.
• The use of automated market makers can be difficult and complex, so users may have difficulty operating AMMs.