A regular centralized cryptocurrency exchange connects buyers with an order book and order matching system with related vendors. The order book is a dynamic, real-time electronic record that maintains and displays all orders to buy or sell cryptocurrency at different prices at any time. The order matching system is a specialized software protocol that matches and resolves orders recorded in the order book. Sometimes, if there are a small number of colleagues to trade with, the user will not be able to fill their bitcoin order at the exchange. When this happens, we say, “Bitcoin market is illiquid.”

In this regard, liquidity is an indicator or a measure of the “availability” or the speed at which an asset can be bought or sold without noticeably affecting its price stability. When a market is illiquid, there aren’t enough available assets or traders within that market. It becomes difficult to execute a trade without significantly affecting the asset’s price on that particular exchange.

In order to guarantee liquidity, centralized exchanges employ professional traders – represented by banks, brokerage houses, and a variety of other financial groups – to continuously provide a “bid-ask spread” on the exchange. In other words, these market makers constantly offer to buy and sell an asset at multiple prices so that users will always have someone to trade against. The process of providing liquidity to the exchange is called market making, and the entities that provide this service are called market makers. The role of the market maker is to make financial markets more efficient and reduce asset price volatility by providing stable liquidity to assets.

AMM (Automated Market Maker) is changing the perception of the financial world of the 21st century. This is a completely new innovative product created in the decentralized financial sector (DeFi) and based on decentralized exchanges (DEXs). It is a method that automates digital asset trading without the need for authorization, and trades are executed automatically using liquidity pools to substitute buyers and sellers. It’s a sort of decentralized exchange (DEX) technology in which the price of assets is determined by a mathematical formula. AMMs are created to change the exchange of cryptocurrencies between users. Instead of the usual buying and selling practice, each party that wants to trade will be pre-funded with liquidity pools in the chain. The liquidity pool allows different users to switch tokens on the chain in a completely different way from the normalized and decentralized way that has been practiced previously. Liquidity pools allow users to easily switch between tokens in a fully decentralized and non-custodial way. Meanwhile, liquidity providers receive passive income from trading commissions, which depend on their share in the pool.

The AMM is built on a transaction method that uses an algorithm to calculate the price of a token right at the time of purchase. The process itself has no concept of sellers; instead, smart contracts act as an intermediary. The seller places the asset in a place called the liquidity pool, and then the buyer exchanges the assets they already have for the assets in the pool via a smart contract.

• The first main feature of an AMM is that it sets a single price for the exchange between 2 digital assets.
• The price set is known and therefore consistently visible to all exchange participants.
• AMMs do not hold equity to facilitate trades but store it from third parties, considered to be participating in this consensus.

The capital thus received is stored in liquidity pools, and those who contribute to maintaining these pools receive a percentage of the trading fees charged by an AMM.