Digital illustration of interconnected gears above a liquid pool, symbolizing AMMs.

Decoding AMMs: How Automated Market Makers are Changing Finance

Jordan Keane in Tech & Innovation December 2025 • 4 min read.

"Unlock the potential of Automated Market Makers (AMMs) and discover their role in democratizing finance, but also potential pitfalls."

Automated Market Makers (AMMs) are at the forefront of decentralized finance (DeFi), revolutionizing how digital assets are traded. Unlike traditional exchanges that rely on order books and central intermediaries, AMMs use algorithms to automate the process of pricing and matching buy and sell orders. This innovative approach leverages blockchain technology and smart contracts, allowing users to trade cryptocurrencies and other digital assets peer-to-peer, securely, and without the need for traditional financial institutions.

One key difference between AMMs and traditional exchanges lies in how prices are determined. In a traditional order book system, prices are dictated by the intentions of individual buyers and sellers. AMMs, however, determine prices based on the available liquidity within a specific pool. This 'liquidity pool' consists of funds deposited by users, known as liquidity providers (LPs). These LPs contribute varying amounts of two or more tokens into a smart contract, creating a readily available source of liquidity for other users to trade against.

Becoming an LP is relatively straightforward, requiring only a self-custody wallet and a selection of compatible tokens. However, LPs face a significant challenge: adverse selection. This occurs when arbitrageurs exploit price discrepancies between AMMs and centralized exchanges, capitalizing on the often slower price updates within AMMs. This can lead to losses for LPs, a phenomenon quantified by the 'loss-versus-rebalancing' (LVR) metric.

Understanding AMM Price Dynamics: A Deep Dive

Digital illustration of interconnected gears above a liquid pool, symbolizing AMMs.

To understand how AMMs function, let’s consider a simplified model with key assumptions:

Imagine a reference market with ample liquidity and no transaction costs. Here, the price of an asset follows a geometric Brownian motion – a statistical model that reflects random price fluctuations over time. The AMM price, however, doesn't float freely. Instead, it is bound by upper and lower limits that are determined by constant multiples of the reference price. These boundaries define a 'no-arbitrage interval'.

Reference Market: A theoretical market with perfect liquidity and zero trading costs, where prices fluctuate randomly.
AMM Price Boundaries: The AMM's price stays within defined high and low price range related to the reference market.
Trading Fees: A small percentage fee (e.g., 1-100 basis points) is applied to each trade within the AMM.
Arbitrageurs: Market participants that constantly watch prices and trade to take advantage of small differences in prices.

This interplay between the reference market, the AMM, trading fees, and arbitrageurs creates a dynamic pricing environment. When the reference market price drifts outside the AMM's price boundaries, arbitrageurs step in to bring the AMM price back into alignment. They buy or sell assets on the AMM until the price reflects the broader market. This model captures the essence of how AMMs maintain price stability while accounting for real-world factors like fees and arbitrage.

The Future of AMMs: Challenges and Opportunities

AMMs represent a significant advancement in decentralized finance, offering automated trading, increased accessibility, and peer-to-peer transactions. However, challenges remain, including mitigating the risk of adverse selection for liquidity providers and optimizing fee structures. As the DeFi landscape evolves, AMMs are poised to play a central role, shaping the future of financial markets and empowering a new generation of investors and traders.

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This article is based on research published under:

DOI-LINK: https://doi.org/10.48550/arXiv.2401.01526,

Title: An Arbitrage Driven Price Dynamics Of Automated Market Makers In The Presence Of Fees

Subject: q-fin.mf

Authors: Joseph Najnudel, Shen-Ning Tung, Kazutoshi Yamazaki, Ju-Yi Yen

Published: 02-01-2024

Everything You Need To Know

What is an Automated Market Maker (AMM) and how does it differ from traditional exchanges?

An Automated Market Maker (AMM) is a decentralized exchange protocol that uses algorithms to automate the process of pricing and matching buy and sell orders. Unlike traditional exchanges which rely on order books and central intermediaries, AMMs allow users to trade digital assets peer-to-peer. They determine prices based on the available liquidity within a specific pool. This innovative approach leverages blockchain technology and smart contracts for secure and direct trading, removing the need for traditional financial institutions. The primary distinction lies in the price discovery mechanism; AMMs use algorithms based on liquidity pools, while traditional exchanges rely on the intentions of individual buyers and sellers reflected in order books.

How do liquidity providers (LPs) contribute to the function of Automated Market Makers (AMMs), and what risks do they face?

Liquidity providers (LPs) are users who deposit funds into a smart contract, creating a liquidity pool for AMMs. They contribute varying amounts of two or more tokens, which other users can then trade against. LPs face the risk of adverse selection, which occurs when arbitrageurs exploit price discrepancies between AMMs and centralized exchanges. Arbitrageurs capitalize on the often slower price updates within AMMs, leading to potential losses for LPs. This loss is often quantified by the 'loss-versus-rebalancing' (LVR) metric, reflecting the impact of these arbitrage activities.

Explain the interplay between the Reference Market, AMM price boundaries, and Arbitrageurs in determining the price of an asset within an AMM.

In an AMM, the price of an asset is influenced by several factors. The Reference Market, a theoretical market with perfect liquidity and zero trading costs, provides a baseline price. The AMM price, however, doesn't float freely but is bound by upper and lower limits determined by constant multiples of the reference price, defining a 'no-arbitrage interval'. Arbitrageurs constantly monitor prices and step in when the AMM price deviates from the broader market, buying or selling assets to bring the AMM price back into alignment within these boundaries. This dynamic pricing environment accounts for real-world factors like fees and arbitrage, with trading fees also affecting the overall price.

What role do trading fees play within Automated Market Makers (AMMs), and how do they impact the trading dynamics?

Trading fees are a crucial element in AMM dynamics. A small percentage fee, typically between 1 and 100 basis points, is applied to each trade within the AMM. These fees serve multiple purposes. They generate revenue for the liquidity providers (LPs), compensating them for providing liquidity. They also influence arbitrage activities; arbitrageurs factor in these fees when determining the profitability of trades. The fees contribute to the overall stability of the AMM price within the boundaries set by the reference price and the no-arbitrage interval. The fees are a part of the AMM's design to make it functional and profitable.

What are the key challenges and opportunities facing Automated Market Makers (AMMs) as decentralized finance (DeFi) evolves?

AMMs, as a cornerstone of decentralized finance, face several challenges and opportunities. A significant challenge is mitigating the risk of adverse selection for liquidity providers, aiming to minimize the losses caused by arbitrageurs exploiting price discrepancies. Optimizing fee structures is another area for improvement to balance the needs of liquidity providers and traders. The opportunities are vast, including the potential to reshape financial markets by offering automated trading, increased accessibility, and peer-to-peer transactions. As the DeFi landscape evolves, AMMs are poised to play a central role in shaping the future of financial markets and empowering a new generation of investors and traders. Addressing the challenges related to price stability, liquidity, and user experience will be critical for wider adoption and sustained growth.