Automatic Market Maker (AMM)
Automatic Market Maker
An Automatic Market Maker (AMM) is a form of decentralized exchange (DEX) that uses a mathematical algorithm as opposed to an order book to determine price. Different AMM may use different algorithms to determine price.
AMM do not require a second party to complete a trade, unlike traditional markets. The liquidity pool contract creates the market for you. Price isn’t set by what someone else is willing to sell for, but rather an algorithm within the AMM. The liquidity in that contract has been supplied already by liquidity providers. As a reward, liquidity providers earn the fees from trades within that pool.
The more liquidity a pool has, the less slippage large trades suffer. Slippage is defined as the expected percentage change between the quoted and executed prices. Large trades on small market cap projects will suffer greatly from slippage, as opposed to if those trades were done in larger projects.
AMMs and liquidity pools are also susceptible to impermanent loss, which will be covered later in this article.