The Original Purpose of AMM: Removing Traditional Market-Making Intermediaries
In traditional finance and centralized exchanges, liquidity is usually provided by professional market-making institutions, which require significant capital, technical resources, and compliance thresholds. One of the biggest challenges faced by early DeFi projects was enabling assets to trade freely without centralized matching or professional market makers. AMM was created to solve this problem.
The core idea behind AMM is to replace manual market-making with algorithms. Through liquidity pools and smart contracts, quotes are generated automatically. When users want to trade, they don’t need to wait for a counterparty, they can exchange directly with the liquidity pool. This eliminates reliance on traditional intermediaries and enables more ordinary users to participate as liquidity providers.
Key concepts behind AMM design include:
- Decentralized participation: Anyone can become a liquidity provider, not just professional institutions.
- Automated pricing: Prices are determined by mathematical formulas instead of order book matching.
- Permissionless trading: Users can trade and provide liquidity without approval.
- Continuous liquidity: Even with low trading volume, basic trading functions are maintained.
This design significantly lowers the liquidity threshold, allowing DeFi to quickly build a trading ecosystem in its early stages.
Constant Product Model and On-Chain Pricing Mechanism
The classic AMM model comes from Uniswap, based on the formula: x * y = k. Simply put, the product of the quantities of two assets in the pool remains constant. When a user trades, the asset ratio changes, and the price adjusts accordingly.
If a pool contains ETH and USDC, when a user buys ETH with USDC, the ETH amount decreases and USDC increases. To maintain the constant product, the price of ETH automatically rises. This mechanism allows AMMs to update prices without an order book.
In practice, on-chain pricing has several distinct features:
- Price is determined directly by asset ratios, not buy/sell orders.
- The larger the trade size, the greater its impact on price, resulting in higher slippage.
- Arbitrageurs trade between different markets, causing AMM prices to gradually align with external markets.
- Every transaction changes the pool’s structure, so prices fluctuate continuously.
Compared to traditional order books, price discovery in AMMs depends more on capital flow than order distribution, leading to different volatility characteristics in on-chain markets.
Liquidity Provider (LP) Revenue Structure and Impermanent Loss
In the AMM system, LPs play a crucial role. They deposit assets into liquidity pools to provide liquidity for traders and earn revenue through fee sharing. Unlike traditional market makers, LPs do not need to actively place orders or adjust prices. These tasks are handled automatically by the system.
LP revenue typically comes from multiple sources such as trading fees, platform token rewards, and additional incentives offered by some protocols. However, LPs must also bear unique risks, the most notable being impermanent loss. When there are significant price changes between the two assets in the pool, the asset ratio is automatically adjusted, potentially causing actual returns to be lower than simply holding the assets.
From an LP perspective, participation usually revolves around several core considerations:
- Higher trading volume usually means higher fee income
- Greater volatility can increase impermanent loss risk
- Smaller pool sizes tend to amplify both returns and risks
- Long-term stable asset combinations are more likely to maintain steady returns
Therefore, LPs are not passive investors, they need to choose strategies based on market conditions, asset types, and protocol mechanisms.
