Automated market makers (AMMs)
Automated Market Makers (AMMs): A Beginner's Guide
Welcome to the world of Decentralized Finance (DeFi)! You've likely heard about trading Cryptocurrencies on exchanges like Register now Binance, Start trading Bybit, Join BingX, Open account Bybit, or BitMEX. But have you ever wondered how trading can happen *without* a traditional order book and a middleman? That's where Automated Market Makers, or AMMs, come in. This guide will break down AMMs in simple terms.
What is an Automated Market Maker (AMM)?
Traditionally, exchanges like the ones listed above use an *order book*. Think of it like a physical stock exchange where buyers and sellers place orders at specific prices. An AMM is different. It’s a type of Decentralized Exchange (DEX) that uses a mathematical formula to price assets. Instead of matching buyers and sellers, AMMs use *liquidity pools*.
Imagine a vending machine. You put in money (one asset) and get a product (another asset) in return. The price is pre-determined, not negotiated. AMMs work similarly.
Understanding Liquidity Pools
A liquidity pool is simply a collection of two or more Tokens locked in a Smart Contract. These pools are created by *liquidity providers* – individuals who deposit their tokens into the pool. In return, liquidity providers earn fees from trades that occur within the pool.
Let's say we have a liquidity pool for ETH/USDC (Ethereum and USD Coin).
- Someone deposits 10 ETH and 20,000 USDC into the pool.
- This creates a pool with a ratio of 1 ETH = 2,000 USDC.
- Traders can then swap ETH for USDC, or USDC for ETH, directly from the pool.
The price isn't set by someone; it's determined by the ratio of tokens in the pool. As more people trade, this ratio changes, and thus, the price changes.
How AMMs Work: The Constant Product Formula
The most common formula used by AMMs is the "constant product" formula: x * y = k
- **x** = the amount of Token A in the pool
- **y** = the amount of Token B in the pool
- **k** = a constant number
This formula ensures that the total liquidity in the pool remains constant. When someone trades, they add one token to the pool and remove the other. This changes the ratio, and therefore the price.
For example, if someone buys 1 ETH from our pool, they add USDC to the pool, increasing 'y'. To maintain 'k', 'x' (the amount of ETH) must decrease. This decrease in ETH supply increases the price of ETH relative to USDC.
== AMMs v
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