AMMs and Liquidity Pools
This blog presents a basic understanding of a very frequent term in the Defi space called AMMs.
AMM
Automated market makers (AMMs) allow digital assets to be traded without permission and automatically by using liquidity pools instead of a traditional market of buyers and sellers. In a traditional market, trade gets executed when buyers and sellers converge upon a price whereas in AMMs, users trade against a pool of tokens called as Liquidity Pool. This new technology is decentralized and does not rely on the interaction of buyers and sellers.
Liquidity Pool and Liquidity Provider
Liquidity refers to how easily one asset can be converted into another asset, often a fiat currency. A Liquidity pool is where users (Liquidity Providers) supply assets to this pool and earn rewards from fees paid by traders interacting with this pool. The platform automatically generates a new token (LP token) that represents the share of the depositor in that pool.
The LP tokens are ERC20 tokens and can be used in other Defi apps. When a trade is facilitated by the pool a 0.3% fee is proportionally distributed amongst all the LP token holders. If the liquidity provider wants to get their underlying liquidity back, plus any accrued fees, they must burn their LP tokens.
To know more about how prices fluctuate in a DEX (Decentralized Exchange), head on to the next article. Stay tuned for more concise articles from the crypto space by twindevs.
This article is co-authored by xenowits and dhruvbodani.
