Automated Market Maker (AMM)

Traditional exchanges match buyers and sellers — two humans agreeing on a price. An AMM replaces that human negotiation with a mathematical formula. You trade against a pool of funds locked in a smart contract, and the formula adjusts the price automatically based on supply and demand.

If you're using DeFi lending platforms like Aave or Compound, AMMs are the plumbing underneath. They're how collateral gets liquidated, how interest rates get discovered, and how liquidity moves between protocols. You may never interact with an AMM directly — but it's working on your behalf every time you open or close a position.

How It Works

Most AMMs use a constant product formula: x × y = k. Say a pool holds 100 ETH and 200,000 USDC — k equals 20,000,000. If you buy 10 ETH, the pool must still equal k, so the USDC side rises and the price of ETH in that pool goes up. The math, not a market maker, sets the new price.

Liquidity providers — people who deposit funds into these pools — earn a share of trading fees in exchange for taking on the risk of holding both assets. On Uniswap v3, fee tiers range from 0.01% to 1% depending on the pool. Those fees are real yield, but they come with strings attached.

For lending protocols, AMMs matter most during liquidations. When a borrower's collateral drops below the required threshold, the protocol needs to sell that collateral fast. It routes through AMM liquidity pools to do it — no waiting for a buyer, no phone call, no negotiation. The smart contract just executes.

Why It Matters

Without AMMs, DeFi lending couldn't function at scale. There'd be no reliable way to price collateral in real time or liquidate positions instantly. The whole system — borrow rates, loan-to-value ratios, liquidation thresholds — depends on deep, accessible liquidity sitting in these pools.

What to Watch

Liquidity pools can be thin. A pool with $500,000 in it will move price dramatically on a $50,000 trade — that gap between the expected price and the actual execution price is called slippage. During volatile markets, slippage gets worse fast. If a liquidation hits a thin pool, the borrower's collateral sells at a worse price than expected, which can accelerate losses.