An automated market maker (AMM) is a system used by decentralized exchanges (DEXs) to encourage people to become liquidity providers so as to facilitate automated trading. In traditional markets, buyers and sellers rely on order books to fill their orders. However, in decentralized finance (DeFi), AMMs are the tools that keep ecosystems liquid.
On AMM-based platforms, instantaneous trades are made possible by the liquidity pools, which are linked pairs of cryptocurrencies on the DEXs. Anyone who possesses the tokens corresponding to the pools can become a liquidity provider, earning passive income for their troubles.
Mathematical formulas are at the center of AMMs and dictate the ratio of the linked assets in a pool, which is maintained by arbitrageurs when it slips. An AMM enables traders to interact trustlessly with each other, as there are no third parties involved in transactions that instead rely on smart contracts.