Explanation
Instead of an order book, providers deposit two tokens into a pool. Each swap shifts the ratio and hence the price. Providers earn part of the trading fees but incur impermanent loss.
A market without an order book
An automated market maker replaces buyers and sellers with a pool of two assets and a mathematical formula. The classic variant keeps the product of both reserves constant: buy from one side and it becomes scarcer and thus pricier. The price therefore moves automatically, with nobody needing to place an order.
Who the counterparty is
The counterparty is you, or rather: everyone who deposited assets into the pool. Those liquidity providers earn a share of trading fees but also bear the risk that the composition of their deposit shifts as prices move — known as impermanent loss. For traders an AMM is mainly attractive because it works without an account or intermediary.
Key takeaways
- Price follows from a formula, not from orders.
- Liquidity providers earn fees and carry risk.
- Large orders cause strong price impact.
Frequently asked questions
+Why does an AMM price sometimes differ?
The pool only follows the market once arbitrageurs correct it. With low liquidity or high network fees that gap can persist for a while.