An automated market maker is a type of decentralized exchange protocol that uses mathematical formulas and liquidity pools to price and facilitate trades, replacing the traditional order book model. In a traditional exchange, buyers and sellers place orders at specific prices, and a matching engine connects them. In an AMM, a smart contract holds reserves of two or more tokens in a liquidity pool. A formula, typically x multiplied by y equals k, determines the price based on the ratio of tokens in the pool. When you trade, you swap one token for another, changing the ratio in the pool and thus moving the price. Uniswap popularized the AMM model and it became the foundation of DeFi. Anyone can provide liquidity to a pool by depositing equal values of both tokens and earning a share of trading fees. AMMs enable permissionless, 24/7 trading for any token pair without requiring counterparties or market makers. The trade-off is capital inefficiency and impermanent loss, the loss liquidity providers experience when token prices diverge significantly. Subsequent AMM designs like Uniswap v3's concentrated liquidity have improved capital efficiency significantly.
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