An automated market maker (AMM) is a trading mechanism that provides liquidity to decentralised exchanges (DEXs), helping users to trade and exchange cryptocurrencies without a middleman.
A tool unique to Ethereum, AMMs bring traditional order books to the decentralised finance (DeFi) space to give agency to users to ideate and innovate solutions while engaging actively within this community. Through liquidity pools (a pile of pre-funded digital assets secured in smart contracts) traders no longer wait for order matching systems to proceed with their trade.
Instead, an AMM provides these traders with autonomy through its algorithm. This enables users to trade against their trading pair pool of choice. An example of this is Uniswap, an Ethereum-based DEX allowing users to supply liquidity and exchange with any pair of ERC-20 tokens.
AMMs play a pivotal role to avoid slippages in pools, enabling greater functionality of these DEXs through reduced transaction fees paid on each execution within the pool. Each pool typically uses a mathematical equation (x*y=k) to fulfil its balance function, causing either pairing token to rise and fall based on user purchase. For larger orders placed on an AMM, as a substantial amount of token is either added or removed, asset pricing can vary from its traded price (based on other exchanges), creating an arbitrage that incentivises traders.