# Automated Market Makers


By [web3 library](https://paragraph.com/@tool3) · 2022-10-16

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(Also known as AMMs)

**What are AMMs?**

*   Automated market makers incentivize users to become liquidity providers in exchange for a share of transaction fees and free tokens.
    
*   An automated market maker (AMM) is the underlying protocol that powers all decentralized exchanges (DEXs)
    
*   DEXs help users exchange cryptocurrencies by connecting users directly, without an intermediary.
    
*   Simply put, automated market makers are autonomous trading mechanisms that eliminate the need for centralized exchanges and related market-making techniques. In this guide, we will explore how AMMs work.
    

**How do they AMMs in DEXs differ from Centralized Exchanges?**

*   Unlike centralized exchanges, DEXs look to eradicate all intermediate processes involved in crypto trading.
    
*   They do not support order matching systems or custodial infrastructures (where the exchange holds all the wallet private keys.)
    
*   As such, DEXs promote autonomy such that users can initiate trades directly from non-custodial wallets (wallets where the individual controls the private key.)
    
*   Also, DEXs replace order matching systems and order books with autonomous protocols called AMMs.
    
*   These protocols use smart contracts – self-executing computer programs – to define the price of digital assets and provide liquidity.
    
*   Here, the protocol pools liquidity into smart contracts.
    
*   In essence, users are not technically trading against counterparties – instead, they are trading against the liquidity locked inside smart contracts.
    
*   These smart contracts are often called liquidity pools.
    
*   Notably, only high-net-worth individuals or companies can assume the role of a liquidity provider in traditional exchanges.
    
*   As for AMMs, any entity can become liquidity providers as long as it meets the requirements hardcoded into the smart contract. Examples of AMMs include [Uniswap](https://uniswap.org/), [Balancer](https://balancer.fi/) and [Curve](https://curve.fi/).
    

**How do AMMs work?**

**There are two important things to know first about AMMs:**

*   Trading pairs you would normally find on a centralized exchange exist as individual “liquidity pools” in AMMs. For example, if you wanted to trade [ether](https://www.coindesk.com/price/ethereum) for [tether](https://www.coindesk.com/price/tether), you would need to find an ETH/USDT liquidity pool.
    
*   Instead of using dedicated market makers, anyone can provide liquidity to these pools by depositing both assets represented in the pool. For example, if you wanted to become a liquidity provider for an ETH/USDT pool, you’d need to deposit a certain predetermined ratio of ETH _and_ USDT
    

**Liquidity Providers in AMMs**

*   As discussed earlier, AMMs require liquidity to function properly.
    
*   Pools that are not adequately funded are susceptible to slippages.
    
*   To mitigate slippages, AMMs encourage users to deposit digital assets in liquidity pools so that other users can trade against these funds.
    
*   As an incentive, the protocol rewards liquidity providers (LPs) with a fraction of the fees paid on transactions executed on the pool.
    
*   In other words, if your deposit represents 1% of the liquidity locked in a pool, you will receive an LP token which represents 1% of the accrued transaction fees of that pool.
    
*   When a liquidity provider wishes to exit from a pool, they redeem their LP token and receive their share of transaction fees.
    
*   In addition to this, AMMs issue [governance tokens](https://www.coindesk.com/learn/what-is-a-governance-token/) to LPs as well as traders. As its name implies, a governance token allows the holder to have voting rights on issues relating to the governance and development of the AMM protocol.
    

**Yield Farming on AMMs**

*   Apart from the incentives highlighted above, LPs can also capitalize on yield farming opportunities that promise to increase their earnings.
    
*   To enjoy this benefit, all you need to do is deposit the appropriate ratio of digital assets in a liquidity pool on an AMM protocol.
    
*   Once the deposit has been confirmed, the AMM protocol will send you LP tokens.
    
*   In some instances, you can then deposit – or “stake” – this token into a separate lending protocol and earn extra interest.
    
*   By doing this, you will have managed to maximize your earnings by capitalizing on the composability, or interoperability, of decentralized finance (DeFi) protocols.
    
*   Note, however, that you will need to redeem the liquidity provider token to withdraw your funds from the initial liquidity pool.
    

**Sources and articles**

*   [https://www.coindesk.com/learn/2021/08/20/what-is-an-automated-market-maker/](https://www.coindesk.com/learn/2021/08/20/what-is-an-automated-market-maker/)
    
*   [https://medium.com/balancer-protocol/what-is-an-automated-market-maker-amm-588954fc5ff7](https://medium.com/balancer-protocol/what-is-an-automated-market-maker-amm-588954fc5ff7)

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*Originally published on [web3 library](https://paragraph.com/@tool3/automated-market-makers)*