In layman’s terms, an automated market maker (AMM) is a type of decentralized exchange (DEX) wherein the fundamental difference lies in the use of mathematical formulas by the automated market makers (AMM) to calculate the rate as compared to the order books on traditional crypto exchanges. AMMs were first implemented by Shearson Lehman Brothers and ATD in the early 1990s, and, since then, they have never lost their popularity. Before the invention of automated market makers (AMM), order books were often created by humans who would initiate trades manually to enhance the liquidity of the market.
This process would often lead to some slippage as well as a lag in the discovery of prices on the markets. Apart from all this, market makers were often accused of tampering with the market prices. AMMs came in handy to resolve every issue about the manual market makers. Blockchain-based decentralized exchanges also use this type of system.
In AMM-based decentralized exchanges, liquidity pools often replace the traditional order books. These liquidity pools are pre-funded on-chain for both the assets present in the trading pair. Wondering where this liquidity comes from? The liquidity is often provided by various users who can also earn passive income through their deposits. Depending on the percentage of the liquidity provided by them, they earn passive income from trading fees.
Uniswap is one of the leading examples of decentralized exchanges that have implemented AMM. Uniswap allows all its users to exchange among various crypto assets and incentivizes supplying liquidity by allowing them to earn passive income.