In traditional finance, securities trading is based on the order book.
However, decentralized finance has developed a revolutionary concept called automated market makers (AMMs).
What they are and main components
AMMs are the trading system of decentralized finance. They are characterized for being decentralized and for being a system totally different from the order book.
They are a structure of code and equations that automates all operational processes. Thus, there is no need for the role of an intermediary and users can trade with each other using this structure.
While the order book is the main component of the traditional trading system, in AMMs the cornerstone is the liquidity pools.
These house the liquidity of a cryptocurrency pair (such as might be USDC-ETH) that has been contributed by liquidity providers.
Liquidity providers need not be only large investment firms as is often the case in traditional finance, these can be individual investors.
When users want to exchange one cryptocurrency for another, they go to the liquidity pools and use the liquidity in them.
The companies that create the AMM structure charge users a commission for each transaction. A part of these commissions is kept by the liquidity providers as a reward for filling the liquidity pools. This is how platforms offering AMMs make a profit and incentivize liquidity providers.
How they work: Pricing and operations
Prices are set automatically by equations. Normally liquidity pools are governed by the equation X * Y = K. Where X and Y are the cryptocurrencies in the pool and k is a constant.
With this formula, prices change according to supply and demand, maintaining the relationship between the assets.
In the event that an excessive demand for one of the cryptocurrencies in a pool causes the prices in that pool to be very different from those offered by other platforms, this would create arbitrage opportunities that many investors would be happy to resolve.
Finally, the operation of AMMs is automated by Smart Contracts.
Both user trades and the commissions charged are executed instantaneously by code, leaving aside any kind of human failure or negligence that an intermediary might have.
As we can see, AMMs are trading systems that work on their own and independently. Once the structure has been created, nothing else is needed.
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