What is an AMM?

How do you swap a token when there’s no one on the other side to take your order? On many decentralized exchanges (DEXs), you trade against a shared pool of funds, not directly with a specific seller.

Think of an automatic exchange machine with two containers: one holds ETH and the other a stablecoin. You put in stablecoins and get ETH out. The machine calculates how much you’ll receive based on predefined rules. That’s the basic logic of an automated market maker, although real-world implementations vary.

The funds sit in a liquidity pool managed by smart contracts. They are deposited by liquidity providers, who usually earn a share of the fees from swaps.

In a typical AMM model, the more ETH is removed from the pool and the more stablecoins are added, the more expensive ETH becomes within it. A swap that is large relative to the available funds moves the price more. Not all AMMs use the same mathematical formula: there are different models for different pairs and ways of providing liquidity.

Why it matters

An AMM enables swaps without an order book, i.e. without a list of buy and sell offers that have to be matched. This makes it easier to run markets inside decentralized finance (DeFi) apps, as long as liquidity is available.

The pool’s price doesn’t necessarily match prices on other exchanges. Traders who exploit these differences through arbitrage usually help bring prices closer together. We think this is worth remembering: automated pricing doesn’t mean a guaranteed good price.

What to watch out for

If you’re swapping, what matters is the available liquidity, the price impact of your trade, fees and network costs. Slippage is the difference between the expected price and the execution price, which can change before the transaction completes.

Liquidity providers face the additional risk of impermanent loss: their position may end up worth less than if they had simply held the same tokens outside the pool. Fees aren’t guaranteed to cover that difference. There are also the risks of bugs in the contracts and of the tokens themselves losing value.