How Automated Market Makers (AMMs) Power Liquidity Pools

If you've searched for decentralized finance (DeFi), you've undoubtedly heard of automated market makers or AMMs. These are strong tools that let anyone trade cryptocurrencies without the need for a typical exchange or middleman.

The definition of AMMs, their relationship to liquidity pools, and their importance in cryptocurrency space will all be covered in this guide. We'll keep things easy and quick for newbies.

What is an AMM?

Unlike traditional markets, which match buyers and sellers, decentralized cryptocurrency exchanges utilize an automated market maker (AMM), a type of computer program, to enable users to purchase and sell tokens straight from a smart contract.

It's essentially a robot that uses a mathematical formula to determine token pricing.

AMMs are used by Liquidity pools to enable trade quickly rather than through a "order book" like on Binance or Coinbase.

What Is AMM in Cryptocurrency?

The algorithm, also known as a smart contract, and the mechanism that facilitates decentralized trading, are both referred to as AMM in the context of cryptocurrencies.

Several well-known AMM platforms  

• Uniswap (on Ethereum)
• The PancakeSwap (BNB Chain)
• curve (pertaining to stablecoins)
• The balancer
• SushiSwap

Token swapping, yield farming and other activities are made possible by these platforms' automated market makers.

How Do AMMs Work?

Now that you have learned about AMM crypto meaning, let us check out the work behind it. AMMs use a pricing formula as an easy way to maintain fair trade. The most often used formula is:

• x * y = k
• x = token A's amount (ETH, for example)
• y = token B's amount (USDT, for example)
• K" is a constant value that must remain constant.

This formula indicates that, without the need for an order book, the price of ETH will increase if more people purchase it and decrease if more people sell it.

Benefits of Automated Market Makers

The following explains why AMMs are so well-liked in the cryptocurrency community:

Example of How an AMM Works

Suppose you wish to exchange one CELO for ETH on a site similar to the well-known AMM cryptocurrency exchange Uniswap.

• The exchange is linked to your cryptocurrency wallet.
• The platform verifies the CELO/ETH pool.
• It determines the price based on the pool's current balance.
• In a moment, CELO is added to your wallet and your ETH is swapped.
• The liquidity providers receive a tiny trading fee.
• Not having to wait for other traders or match orders makes it quick and easy.

Risks of Using AMMs

Automated Market maker crypto have a number of advantages, but they also carry certain risks.

Prior to using an AMM crypto platform, always conduct a study.

How to Use an AMM: Step-by-Step Guide

Now that we have taken benefits and risks into account, let’s take a look at the step-by-step setup and see how to use an AMM.  

Step 1: Choose an AMM Platform

Not all crypto platforms use automated market makers. But for the ones that do, you need to pick the platform based on the blockchain that you are using, and the tokens you wish to swap. Some popular examples include Uniswap (Ethereum) and PancakeSwap (BNB Chain).

Step 2: Connect Your Wallet

Next, you will need to connect a crypto wallet, like Coinbase Wallet or MetaMask. For doing so, you simply need to visit the website of your selected AMM, and click on 'Connect Wallet'.

Step 3: Select What You Want to Do

AMMs usually perform two main functions. So, now choose whether you want to 'swap tokens' or 'provide liquidity'.

Step 4: Confirm the Transaction

Once you have selected what you want to do, and entered the relevant amount, review your options. The selected platform will then show you a preview including fees and slippage. You can then ‘confirm your transaction.

Always double-check the site URL to avoid phishing scams and make sure the AMM you’re using is well-established or audited.

Common Mistakes to Avoid with AMMs

While AMMs are user-friendly, there are pitfalls in it that can cost you time or money. Let's look at some of the common mistakes crypto users make while using amm cryptocurrency.

1. Not Understanding Impermanent Loss

The most common mistake crypto users make is investing in liquidity pools without first knowing what an impermanent loss is. Providing liquidity for any platform earns your fees, but when token prices are far apart, the prices may drop - and that, ultimately, impacts your earnings. So not knowing the impact of impermanent loss on AMMs can be a big mistake.

2. Using Unverified Platforms

New or unverified AMM platforms can have vulnerabilities which ultimately pose a threat to your crypto wallet. So, carry out thorough research before connecting your wallet to an AMM platform, or depositing funds.

3. Ignoring Slippage Settings

If you don't make room for slippage tolerance, you may end up with lesser tokens than expected, especially when operating in volatile markets. Therefore, educating yourself on slippage costs is crucial.

4. Not Accounting for Gas Fees

Much like slippage costs, keeping an account of gas fees is also important. Blockchain networks, like Ethereum, charge gas fees that can eat up your profits, so always check the transaction cost before confirming it.

Future Trends in AMMs

One of the most major changes in cryptocurrency is automated market creation. It makes trade quick, equal, and accessible to everybody. In the future, we can expect this to get better.

• Smarter, More Complex AMM Designs

Next-gen AMMs will go beyond the basic x*y=k formula. Developers are now experimenting with more dynamic pricing models that are more concentrated in liquidity. You can also expect AI-driven trading strategies to make their way into the AMM world and optimize trades in real-time.

• Cross Chain Liquidity Pools

With more blockchains entering the defi ecosystem, AMMs will increasingly support cross chain trading, allowing users to swap tokens or assets across blockchain networks.

• More User-Friendly Interfaces

As crypto user adoption grows, you can also expect AMMs to focus more on sleek, mobile-first designs. The emphasis will be more on beginner-friendly dashboards because defi isn’t just for coders anymore, and AMMs are adapting to welcome mainstream users.

Final Words

Automated Market Makers (AMMs) are smart contracts that make crypto trading possible without the need for middlemen. They rely on liquidity pools to power fast, decentralized transactions.  

While AMMs offer simplicity and opportunity, it's important to understand the risks, such as impermanent loss and smart contract vulnerabilities. Still, if you're looking to get hands-on with DeFi, liquidity pools are a great place to start.

Ready to learn more about liquidity pools? Check out our detailed guide on how you can become a liquidity pool provider in 2025.