Automated Market Maker (AMM)

An automated market maker is a type of decentralized exchange protocol that relies on mathematical formulas to price assets instead of a traditional order book. Liquidity providers deposit pairs of tokens into a smart contract, creating a pool that traders can interact with directly.

The price of the assets in the pool is determined by the ratio of the tokens, following a constant product formula. This innovation allowed for the creation of permissionless, 24/7 trading environments without the need for centralized market makers.

AMMs are the backbone of the DeFi ecosystem, providing the infrastructure for most token swaps. They do, however, introduce risks like impermanent loss for liquidity providers and slippage for traders.

Arbitrageurs are essential to AMMs, as they constantly trade against the pool to ensure the price remains consistent with external market data. Their presence ensures that the AMM's internal pricing accurately reflects the broader market.