Automated Market Makers are a key concept in DeFi: an AMM is a decentralized exchange protocol that allows settling transactions autonomously, without relying on an order book. Here's how it works:
Any transaction requires that two parties (a buyer and a seller) agree on a price. Traditionally, brokers facilitate this, managing an order book that contains both sides’ offers. However, in an AMM price is defined by a mathematical formula called bonding curve, which determines a price depending on that asset’s liquidity relating to another asset. And that price changes every time someone trades because liquidity changes too. Complex, we know, let’s try an example:
- In our AMM, we only trade two assets: dollars and bitcoins. Initially, there are $100 and 100 BTC, so 1 BTC = $1.
- A trader arrives and buys 10 BTC at $1, leaving 90 BTC at our AMM and $110.
- Now the price is higher: our AMM has fewer BTC.
AMMs push decentralization even one step further. They are central in DeFi, and a leap forward in the automation of financial relations. AMMs and liquidity pools are two of the main cogs in the DeFi clockwork. Two simple inventions that embody the spirit of decentralization that fuels the crypto economy and that are likely to rock the traditional finance world.