What Is an AMM? Automated Market Makers Explained

An AMM, or automated market maker, is a piece of software that will always trade with you. Instead of matching your buy against somebody else's sell, it holds a pot of two tokens and works out the price from a simple formula: the more of one token you take out, the more expensive the next unit becomes. Uniswap is the best-known example. Every swap you make there is a trade with an AMM, not with another person.

How is that different from an exchange order book?

On a normal exchange, buyers and sellers post prices and wait for someone to accept. That list of offers is the order book, and if nobody is selling what you want, you simply cannot buy it. An AMM removes the waiting. It is a vending machine that reprices itself: take three bottles and the fourth costs more, because the machine is running low. There is always something in the machine, so there is always a price.

Where does the money in the pot come from?

From ordinary people. Anyone can deposit a pair of tokens into a liquidity pool and, in return, earn a cut of the fee on every trade that passes through it. On Uniswap that fee is usually a fraction of a percent per swap, split among everyone who supplied the pot. It is not free money: while your tokens sit there, the pool keeps rebalancing them, and you can end up with less value than if you had just held the two tokens yourself.

What should a first-time swapper watch for?

Two things. Small pools move a lot on a single trade, so a large order in a thin pool can execute at a much worse price than the one on screen. And every AMM asks you to set a slippage tolerance, which is how far the price may drift before your swap is cancelled. Leave it low.

Before you swap anything unfamiliar, check how deep the pool is and trade a small amount first. If a token can only be bought through one tiny pool nobody has heard of, treat that as a warning rather than an opportunity.