What is an automated market maker? A plain guide to AMMs

An automated market maker, or AMM, is a program that lets you trade one crypto token for another without a buyer on the other side. Instead of matching orders, it swaps your tokens against a shared pool of funds and sets the price with a fixed math rule. No broker. No waiting. It runs on a smart contract, around the clock.

AMMs are the engine behind most decentralized exchanges. Uniswap, the largest, explained the idea in a May 1, 2025 post: an AMM is "a type of decentralized exchange that runs on smart contracts, not order books, letting users swap tokens with minimal friction." This guide covers how that works, who puts up the money, and the one risk every liquidity provider should understand first.

The problem AMMs set out to solve

On a traditional exchange, prices depend on market makers, the firms and traders who constantly post buy and sell orders. When enough of them compete, trading is smooth. When few show up, as happened for years with smaller crypto tokens, spreads widen and orders sit unfilled.

An AMM hands that job to code. Chainlink calls AMMs decentralized exchanges that use algorithmic "money robots" to provide liquidity for traders buying and selling crypto assets. The pool plays the role a human market maker used to, quoting a price for any size at any hour, as long as there are funds inside it.

How a liquidity pool replaces the order book

A normal exchange keeps an order book. Buyers post bids, sellers post asks, and a trade happens when the two sides meet at a price. If nobody wants to sell at your price, you wait.

An AMM throws that model out. In its place sits a liquidity pool, a smart contract holding reserves of two tokens, say ETH and the dollar-pegged stablecoin USDC. You trade against the pool directly, not against another person. Chainlink, which builds the price feeds many of these pools rely on, calls a pool "a crowdsourced collection of crypto assets that the AMM uses to trade with people buying or selling one of these assets."

What changes in practice is availability. A pool is always open and always quotes a price. The more funds sit in it, the larger the trade it can absorb without moving the price much. Think of it less like a stock exchange floor and more like a currency kiosk that never closes and never runs out of cash. If the dollar-pegged side is new to you, our guide to stablecoins explains how tokens like USDC hold their value.

The formula that sets the price

A pool needs a way to set its price without a human quoting one. That job falls to a rule called the constant product formula, written as x times y equals k. Here x and y are the amounts of the two tokens in the pool, and k is the result of multiplying them. That result has to stay the same after every trade.

Take Uniswap's own example. A pool starts with 10 ETH and 20,000 USDC. Multiply them and k is 200,000. At that ratio, one ETH costs 2,000 USDC. Now a trader buys 1 ETH. The pool is left with 9 ETH, so to hold k at 200,000 the USDC side has to climb to about 22,222.22. The buyer effectively paid 2,222.22 USDC for that single ETH, more than the 2,000 it started at.

That jump is the point. Every swap shifts the balance of the two tokens, and the formula pushes the price toward whatever is getting scarce. Buy ETH and ETH gets pricier. Sell it and ETH gets cheaper. Run it the other way and the same rule holds. Math does the rest, with no order book and no human quote behind it, just the ratio inside the pool.

From your side a swap stays simple. You pick the two tokens, type an amount, and the app quotes what you will receive from the current pool ratio. You approve it, the contract moves your tokens in and sends the other token out in a single step, and the pool itself is the counterparty. No order has to be accepted by anyone. The formula handles the price.

Who supplies the money, and what they earn

The tokens in a pool come from people called liquidity providers, or LPs. Anyone can be one. You deposit equal values of both tokens, ETH and USDC in our example, and the pool grows. In return you collect a share of every trading fee the pool charges.

Deposits go in equal value on both sides, which matters more than it first looks. Because you hold both tokens, your stake rises and falls with the pool as trades rebalance it. When traders buy ETH, the pool holds less ETH and more USDC, and your share reflects that new mix when you withdraw. That shifting mix is the seed of the risk covered next.

Chainlink describes the reward plainly: AMMs "reward them with a fraction of the fees generated on the AMM, usually distributed as LP tokens." Those LP tokens are your receipt. They track your slice of the pool, and you hand them back to withdraw your deposit plus whatever fees it earned.

This is where the appeal sits for many people. A pool can pay fees every hour of every day, with no application form and no middleman. It is also where the trouble starts, which the risk section below gets to.

Slippage and why big trades move the price

One term you will meet fast is slippage. It is the gap between the price you expect and the price you actually get. On an AMM it comes straight from the formula.

Because each swap changes the token balances, a large trade walks the price along as it executes. Uniswap puts it simply: "larger trades (relative to the pool size) cause more slippage." A small swap in a deep pool barely moves the price. A big swap in a thin pool can move it a lot.

Depth is the fix. The more liquidity in the pool, in Uniswap's words, "the easier it is to make large trades with minimal price impact." Most AMM apps let you set a slippage limit, so a trade cancels on its own if the price moves past a point you choose.

Impermanent loss, the risk every LP carries

Here is the catch nobody should skip. When the market price of the two pooled tokens drifts apart, a liquidity provider can end up with less value than if they had simply held the tokens in a wallet. The name for that gap is impermanent loss.

Chainlink defines it as "the difference in value over time between depositing tokens in an AMM versus simply holding those tokens in a wallet," and says it shows up when "the market-wide price of tokens inside an AMM diverges." The wider the price moves, in either direction, the bigger the gap.

A quick way to picture it. If one token in your pair doubles in price while the other holds flat, the AMM sells off some of the rising token as traders buy it from the pool. You walk away holding less of the winner than if you had kept both tokens untouched in a wallet. That shortfall is what Chainlink points to, and the fees are what you earn for carrying it.

It is called impermanent because the gap can shrink if prices drift back toward where they started. It turns real only when you withdraw. Trading fees can offset it, sometimes in full. Sometimes they do not. Providing liquidity is not free money, and no formula removes the risk.

What to check before you add funds

A few plain points before you put money in a pool. An AMM does not promise you more than holding would. It pays fees in exchange for you taking on impermanent loss and smart contract risk. Pools can also be drained when the underlying code has a bug, so the contract behind a pool matters as much as the yield on offer. Start small. Read the contract. Most AMMs run on networks like Ethereum, so our guide to Ethereum is a sensible next stop if the smart contract part is new.

Keep the pair in mind. The token pair you choose, and how much its price swings against itself, drives most of what you walk away with. A volatile pair earns more fees but carries more impermanent loss. A stable pair does the reverse. There is no setting that gives you high fees and zero risk at once.