Automated Market Maker

An automated market maker (AMM) is a type of decentralized exchange that uses algorithmic pricing formulas rather than order books to determine asset prices and execute trades. Instead of matching buyers with sellers at a mutually agreed price, an AMM maintains liquidity pools containing pairs of assets — for example, ETH and USDC — and prices trades according to a predetermined formula, most commonly the constant product model x * y = k, where x and y are the quantities of the two assets and k is a constant that must be preserved after every trade.

The constant product model ensures that the pool always has liquidity for any trade size, but at a price that moves against the trader: as one asset is bought, its price rises relative to the other. This pricing curve is not a market in the traditional sense; it is a mechanism designed so that rational arbitrageurs — who compare the AMM price to prices on centralized exchanges — will continuously rebalance the pool, keeping its price aligned with the broader market. The AMM does not discover prices. It delegates price discovery to arbitrageurs.

The vulnerability is structural. The pricing formula assumes continuous arbitrage and infinite liquidity at every price point. In reality, during market stress, arbitrageurs may be unable or unwilling to trade, leaving the AMM with prices that diverge sharply from reality. The "impermanent loss" that liquidity providers experience is not a temporary fluctuation but a permanent wealth transfer from providers to informed traders. The AMM is not a neutral infrastructure; it is a mechanism with a built-in adverse selection problem that its elegant mathematics obscures.