Automated Market Makers (AMMs) have emerged as a popular mechanism for facilitating decentralized exchanges within the DeFi ecosystem. Unlike traditional order book models, AMMs employ liquidity pools managed by smart contracts to enable asset trading. The core principle behind AMMs is the constant product formula, which dictates that the product of the quantities of two assets in the pool must remain constant during trades.

This formula underpins the pricing dynamics and liquidity provision within an AMM. It is visually represented by the bonding curve, which illustrates the exchange rates between the two assets and the potential slippage incurred during trades. Slippage refers to the price change experienced due to the trade size relative to the available liquidity (expected slippage) or other transactions executing before the intended trade (unexpected slippage).

To mitigate excessive slippage, AMMs typically allow users to set a maximum tolerable slippage threshold, beyond which their trade will fail to execute, protecting them from unfavorable pricing. While AMMs offer advantages such as simplified implementation, low gas costs, and the elimination of order book maintenance, they also introduce certain risks and trade-offs.

One significant risk for liquidity providers is impermanent loss, where the value of their deposited assets can decrease relative to the external market due to price fluctuations between the two assets. Additionally, AMMs can suffer from high slippage in low liquidity markets, potentially resulting in poor execution prices. Furthermore, users are vulnerable to sandwich attacks, where malicious actors intentionally execute trades before and after a victim’s trade to extract maximum slippage.

Despite these challenges, AMMs have played a crucial role in facilitating decentralized trading and fostering the growth of the DeFi ecosystem by providing a trustless and automated mechanism for asset exchange.