To understand what an AMM is, let’s first look at what a market maker actually is.
What is a market maker?
Anyone who has an account with a broker can place a buy or sell order there with a limit price.
An Apple share is currently trading at around $172. I could now place an order with a buy price of, say, $150.
This is well below market value and presumably no one will sell me their Apple shares for this price. However, if a seller were to place a sell market order now and no one else would bid more than $150, I would get the shares at that bargain price. To prevent such extreme deviations from occurring and to keep prices reasonably stable, there are so-called market makers. Market makers are usually other brokers who participate in the market with tighter spreads in order to generate “a market”. Market makers provide the liquidity necessary to make movements in the markets occur at all. Without market makers, the spread on many financial products would be too wide and trading would grind to a halt.
What is an automated market maker?
Let’s say you want to trade CRO for USDC, you give away your CRO tokens and get USDC in return. With a normal exchange, there would always have to be a matching seller for every buyer, otherwise no trade would occur. With automated market makers, the liquidity providers throw their tokens into a pot and thus provide the necessary liquidity. The current price is then calculated by algorithms. If a trader now exchanges CRO for USDC, then he gets the USDC from the pot and the CRO are added to the pot. Later, perhaps another trader comes who exchanges USDC for CRO and so the whole thing balances out again.