An automated market maker is a system used to power a decentralized crypto exchange (DEX). The automatic systems removes the need for manual market-making. A DEX gives users access to a liquidity pool of assets that they can trade.
What is Market Making?
In centralized exchanges, the platform always acts like a middleman in transactions. For instance, imagine that trader A wants to buy bitcoin at $50k. Yet bitcoin is trading at $50.5k. The CEXes must find someone willing to sell their assets at the bid price of $51k. If they do not get a person ready, then the market may have low liquidity.
CEXes use professional traders to do the market making. The large institutions create many bids and are always ready to act on each at any time. Thus, any trader can get assets at their bid price.
How Does an Automated Market Making Work?
Like CEXes, DEXes always need liquidity to have trade flow. Using the AMM’s traders can buy and sell assets without fearing for liquidity. In DEXes, AMMs do the work of professional traders by ensuring that liquidity is always available. The AMMs can define the required prices and provide liquidity.
AMMs do not depend on other counterparties to provide the required liquidity. Instead, they get liquidity from smart contracts called liquidity pools. Liquidity pools are systems that store the liquidity of a particular asset.
In DEXes, once you put your bid, you don’t wait for another party to trade with. Instead, you trade with the AMM using the pooled funds. If you want to trade ETH for USDT, you must find the ETH/USDT pool. One interesting fact is that in AMMs, anyone can offer liquidity.
Liquidity Providers in AMMs
AMMs allow traders to deposit some assets in pools to provide liquidity. The liquidity providers often gain rewards for providing the liquidity.
In the case of an ETH/USDT pool, the liquidity provider can add some amount of either ETH or USDT. The providers then gain a fraction of the transaction fee paid.