Automated Market Makers (AMMs) are a type of decentralized exchange protocol that relies on a mathematical formula to price assets. Unlike traditional order books, AMMs use liquidity pools — smart contracts that hold reserves of two or more tokens — to facilitate trading.
The most common AMM formula is the constant product formula: x * y = k, where x and y represent the quantities of two tokens, and k is a constant. When a trade occurs, the ratio between the tokens changes, which adjusts the price. Larger trades relative to the pool size cause greater price impact, known as slippage.
Liquidity providers (LPs) deposit equal values of both tokens into a pool and earn a percentage of trading fees in return. However, LPs also face impermanent loss — a temporary reduction in value compared to simply holding the tokens — when token prices diverge significantly from their ratio at the time of deposit.