🔧Automated Market Maker (AMM) mechanism

The concept of Automated Market Maker (AMM) was first proposed by a team of developers at Bancor in 2017. The team included Eyal Hertzog, Guy Benartzi, and Galia Benartzi.

"This mechanism automatically matches buyers and sellers through smart contracts, instead of traditional order book exchanges. In an AMM, the liquidity pool is provided by liquidity providers, and prices are calculated based on the supply and demand of assets, so the price of assets automatically adjusts during the trading process. This mechanism is widely used in decentralized exchanges (DEX), and PancakeSwap is one of them."

📌 Introduction to Automated Market Maker (AMM) Mechanism

When using the Automated Market Maker (AMM) mechanism for trading, the proportion of each asset in the asset pool, known as the asset's weight, determines the price of each asset in the pool. Here's a general method for calculating asset prices:

Assume there are two assets, A and B, with initial prices of a and b, respectively. When a user adds x units of A tokens to the asset pool, the number of A tokens in the pool increases while the number of B tokens decreases accordingly. Therefore, according to the design of the AMM mechanism, the total value of assets A and B in the pool must remain constant. Hence, when a user adds A tokens, the new price of B tokens can be calculated as follows:

📌 Calculation of Asset Prices in AMM Mechanism

(Initial price of B) / (Initial price of A) = (New price of B) / (New price of A + x)

From the equation above, we can get :

New price of B = (Initial price of B * (New price of A + x)) / Initial price of A

For example, if the price of A tokens is 1 ETH and the price of B tokens is 0.5 ETH, and a user adds 10 A tokens to the asset pool, the new price of B tokens would be:

New price of B = (0.5 ETH * (1 ETH + 10 ETH)) / 1 ETH = 5.5 ETH

Therefore, adding 10 A tokens would increase the price of B tokens from 0.5 ETH to 5.5 ETH. This price change will be reflected on the exchange to ensure that all users can trade at the new price.

When a user wants to buy or sell tokens from the asset pool, the AMM mechanism will use a similar algorithm to calculate the new price to reflect the impact of the trading pair on the asset pool. Then, the AMM mechanism will calculate the transaction fee and distribute it to users who provide liquidity to the asset pool. This process ensures the liquidity of trades and facilitates their occurrence.

📌How does it work ？

1.Liquidity providers (LPs) add funds to a liquidity pool, which consists of two assets, for example, BNB and BUSD.

2.The ratio of the two assets in the pool determines the price of each asset. For instance, if the BNB/BUSD pool has 100 BNB and 10,000 BUSD, the price of BNB will be 100 BUSD.

3.0When a user wants to buy or sell an asset, they trade with the liquidity pool, not with another user. For example, if a user wants to buy BNB with BUSD, they would send BUSD to the pool and receive BNB in return. The price of the trade is determined by the ratio of assets in the pool.

4.Each time a trade occurs, the ratio of assets in the pool changes, which affects the price of each asset. The price of an asset increases when the demand for it exceeds the supply, and it decreases when the supply exceeds the demand.

5.Liquidity providers earn a fee for providing liquidity to the pool. The fee is a percentage of the trading volume and is distributed proportionally to the LPs based on their contribution to the pool.

Overall, the AMM mechanism allows for a decentralized and permissionless way of trading assets, without the need for a centralized order book or intermediary. The price of assets is determined by the ratio of assets in the liquidity pool and automatically adjusts based on supply and demand.

📌 Advantages of AMM Mechanism

1.The Automated Market Maker (AMM) mechanism has several advantages over traditional order book-based trading on centralized exchanges.

Provides Higher Liquidity: The AMM mechanism uses asset pools to facilitate trading, which ensures that there is always sufficient liquidity available for traders. This eliminates the need for traders to wait for buyers or sellers to match their orders.

2.No Order Book Needed: The AMM mechanism doesn't require an order book to facilitate trades. Instead, it uses mathematical algorithms to determine the prices of assets in the pool. This makes trading simpler and more accessible to users.

3.Decentralized and Transparent: The AMM mechanism is used on decentralized exchanges (DEXs), which means that trading is transparent and not controlled by a central authority. This ensures that traders can trust the system and have control over their assets.

In conclusion, the AMM mechanism plays an important role in facilitating trading on decentralized exchanges. While it has several advantages over traditional order book-based trading, it also has limitations that traders should consider before using it. As the use of DEXs continues to grow, the AMM mechanism is likely to become more prevalent and continue to evolve.