Understanding Automated Market Makers: A Beginner’s Guide to DeFi Liquidity
The cryptocurrency space can often feel overwhelming, especially when you're just starting out. Between technical jargon, rapidly evolving technology, and a firehose of new platforms and tools, it's hard to know where to begin. One of the foundational innovations of decentralized finance (DeFi) that's worth understanding early on is the Automated Market Maker, or AMM.
In this guide, we'll break down what AMMs are, how they differ from traditional market makers, and how innovations like CoW AMM are taking this technology even further - making decentralized trading more secure, efficient, and fair.
What Is an Automated Market Maker?
Let's start with the basics.
In traditional finance, when you want to buy or sell a stock, your trade is matched through an order book - a system that pairs buyers and sellers. This system usually requires market makers - typically large institutions or traders - who provide liquidity by offering to buy and sell assets at certain prices. Their job is to ensure smooth trading and reduce volatility.
In contrast, Automated Market Makers (AMMs) are a decentralized alternative. Instead of relying on human market makers or order books, AMMs use smart contracts (self-executing code on a blockchain) to enable peer-to-peer trading.
Enter Liquidity Pools
Here's how it works in simple terms:
AMMs rely on liquidity pools - essentially shared pots of tokens. These pools are filled by users called liquidity providers (LPs) who deposit two tokens into the pool in equal value. For example, a common trading pair might be ETH/USDC, where someone deposits an equal dollar amount of Ethereum (ETH) and the stablecoin USDC.
These deposited tokens then become available for others to trade against. Rather than matching with another individual trader, users trade against the pool itself, and a mathematical formula adjusts the price based on the ratio of the two tokens.
Example: The Constant Product Formula
Most AMMs, like those used in Uniswap, use a formula that looks like this:
x * y = k
Where:
-
x = amount of Token A
-
y = amount of Token B
-
k = constant (remains unchanged)
If someone wants to buy Token A, they must add Token B to the pool. This shifts the balance, increasing the price of Token A slightly, creating the supply-and-demand curve that you'd expect in any market.
This method ensures there's always a price and always liquidity - even if no one else is around to trade.
There are other types of pool that use different formulas to create what are called weighted pools, but in this example we're going to stick with the most common type of AMM.
Why Are AMMs a Big Deal?
AMMs are at the heart of DeFi because they remove the need for intermediaries. Here's why they're a major innovation:
1. They're Always Open
Unlike centralized exchanges, which might have downtime or rely on limited liquidity during off hours, AMMs are available 24/7. As long as there's liquidity in the pool, you can trade.
2. Anyone Can Provide Liquidity
In traditional finance, only big players act as market makers. In AMMs, anyone with crypto can contribute to a liquidity pool and earn fees from trades - democratizing access.
3. They're Non-Custodial
You never give up control of your assets to a centralized platform. Everything happens on-chain, and your wallet always holds your funds until you actively interact with a smart contract.
The Downsides of AMMs
AMMs aren't perfect. As with any tool, there are trade-offs:
Impermanent Loss
If you provide liquidity to a pool and the price of one token changes significantly compared to the other, you might end up with less money than if you'd simply held onto your tokens. This phenomenon is called impermanent loss.
MEV (Maximal Extractable Value)
Here's where things get a bit tricky: On public blockchains, anyone can see pending transactions. Some sophisticated bots and traders use this visibility to front-run trades - they jump ahead in line and profit from the price movements that your trade causes.
This is part of a broader problem called Maximal Extractable Value(MEV) - where someone extracts value from a block by strategically ordering transactions. And unfortunately, regular users and liquidity providers often lose out in this process.
Find out more about MEV and how it works here.
Loss Versus Rebalancing (LVR)
LVR is a form of arbitrage that occurs whenever an AMM has an outdated (stale) price in comparison to some other trading venue. Arbitrageurs exploit this difference by trading from the AMM to the more liquid exchange (usually a centralized exchange like Binance), correcting the arbitrage and extracting value from LPs in the process.
Find out more about LVR and how it works here.
Introducing CoW AMM: A New Kind of AMM
This is where CoW AMM comes in - a novel approach developed by CoW DAO that addresses some of the most pressing issues facing current AMM models.
Let's explore how this system works and why it might represent the next evolution in decentralized trading.
What Makes CoW AMM Different?
Protection from MEV
CoW AMM tackles MEV head-on by using batch auctions and intent-based trading.
Rather than letting every trade hit the chain instantly (and visibly), CoW AMM allows multiple trade "intents" to be submitted off-chain. Then, these intents are matched and executed together in a single batch.
Because all trades are processed simultaneously, there's no opportunity for front-running - bots can't jump ahead and exploit your trade.
This process happens through a solvers network - specialized bots that compete to offer users the best execution. It's a win-win for both users and liquidity providers.
Capital Efficiency & Enhanced Yield
Traditional AMMs spread liquidity across the entire possible price range. That means your tokens might sit unused if no trades happen near their price.
CoW AMM allows LPs to concentrate their liquidity into targeted price ranges - making better use of capital and increasing the chance that they'll earn trading fees.
It works similarly to how index funds concentrate around certain market segments. That's why a CoW AMM - once new features have been deployed - acts as an "enhanced index fund" for DeFi - your funds are passively managed, but smartly deployed for better returns.
Real-Life Example: CoW AMM in Action
Let's say you want to swap 1 ETH for USDC using CoW AMM.
-
You submit an "intent to trade" - a request that says, "I want to swap 1 ETH for the best possible amount of USDC."
-
Your intent goes into a batch with many others.
-
CoW Protocol's solver network analyzes the best path for execution - across multiple pools, DEXs, or even aggregators.
-
The batch is executed, and you receive your USDC - with less slippage, no MEV, and often a better price than on a traditional AMM.
As a result, users trade with confidence, and LPs see better yields.
Why This Matters (Especially for Beginners)
CoW AMM's design brings professional-level optimization to everyday users. You don't need to understand complicated strategies or monitor the markets constantly. Just deposit tokens, or trade when you need to - and the system handles the rest with fairness and efficiency.
For beginners, this means:
-
No need to worry about front-running or being "gamed"
-
Easier, smoother trades with better pricing
-
A safer and more welcoming introduction to DeFi
Traditional Market Makers vs. AMMs vs. CoW AMMThe cryptocurrency space can often feel overwhelming, especially when you're just starting out. Between technical jargon, rapidly evolving technology, and a firehose of new platforms and tools, it's hard to know where to begin. One of the foundational innovations of decentralized finance (DeFi) that's worth understanding early on is the Automated Market Maker, or AMM.
In this guide, we'll break down what AMMs are, how they differ from traditional market makers, and how innovations like CoW AMM are taking this technology even further - making decentralized trading more secure, efficient, and fair.
What Is an Automated Market Maker?
Let's start with the basics.
In traditional finance, when you want to buy or sell a stock, your trade is matched through an order book - a system that pairs buyers and sellers. This system usually requires market makers - typically large institutions or traders - who provide liquidity by offering to buy and sell assets at certain prices. Their job is to ensure smooth trading and reduce volatility.
In contrast, Automated Market Makers (AMMs) are a decentralized alternative. Instead of relying on human market makers or order books, AMMs use smart contracts (self-executing code on a blockchain) to enable peer-to-peer trading.
Enter Liquidity Pools
Here's how it works in simple terms:
AMMs rely on liquidity pools - essentially shared pots of tokens. These pools are filled by users called liquidity providers (LPs) who deposit two tokens into the pool in equal value. For example, a common trading pair might be ETH/USDC, where someone deposits an equal dollar amount of Ethereum (ETH) and the stablecoin USDC.
These deposited tokens then become available for others to trade against. Rather than matching with another individual trader, users trade against the pool itself, and a mathematical formula adjusts the price based on the ratio of the two tokens.
Example: The Constant Product Formula
Most AMMs, like those used in Uniswap, use a formula that looks like this:
x * y = k
Where:
-
x = amount of Token A
-
y = amount of Token B
-
k = constant (remains unchanged)
If someone wants to buy Token A, they must add Token B to the pool. This shifts the balance, increasing the price of Token A slightly, creating the supply-and-demand curve that you'd expect in any market.
This method ensures there's always a price and always liquidity - even if no one else is around to trade.
There are other types of pool that use different formulas to create what are called weighted pools, but in this example we're going to stick with the most common type of AMM.
Why Are AMMs a Big Deal?
AMMs are at the heart of DeFi because they remove the need for intermediaries. Here's why they're a major innovation:
1. They're Always Open
Unlike centralized exchanges, which might have downtime or rely on limited liquidity during off hours, AMMs are available 24/7. As long as there's liquidity in the pool, you can trade.
2. Anyone Can Provide Liquidity
In traditional finance, only big players act as market makers. In AMMs, anyone with crypto can contribute to a liquidity pool and earn fees from trades - democratizing access.
3. They're Non-Custodial
You never give up control of your assets to a centralized platform. Everything happens on-chain, and your wallet always holds your funds until you actively interact with a smart contract.
The Downsides of AMMs
AMMs aren't perfect. As with any tool, there are trade-offs:
Impermanent Loss
If you provide liquidity to a pool and the price of one token changes significantly compared to the other, you might end up with less money than if you'd simply held onto your tokens. This phenomenon is called impermanent loss.
MEV (Maximal Extractable Value)
Here's where things get a bit tricky: On public blockchains, anyone can see pending transactions. Some sophisticated bots and traders use this visibility to front-run trades - they jump ahead in line and profit from the price movements that your trade causes.
This is part of a broader problem called Maximal Extractable Value(MEV) - where someone extracts value from a block by strategically ordering transactions. And unfortunately, regular users and liquidity providers often lose out in this process.
Find out more about MEV and how it works here.
Loss Versus Rebalancing (LVR)
LVR is a form of arbitrage that occurs whenever an AMM has an outdated (stale) price in comparison to some other trading venue. Arbitrageurs exploit this difference by trading from the AMM to the more liquid exchange (usually a centralized exchange like Binance), correcting the arbitrage and extracting value from LPs in the process.
Find out more about LVR and how it works here.
Introducing CoW AMM: A New Kind of AMM
This is where CoW AMM comes in - a novel approach developed by CoW DAO that addresses some of the most pressing issues facing current AMM models.
Let's explore how this system works and why it might represent the next evolution in decentralized trading.
What Makes CoW AMM Different?
Protection from MEV
CoW AMM tackles MEV head-on by using batch auctions and intent-based trading.
Rather than letting every trade hit the chain instantly (and visibly), CoW AMM allows multiple trade "intents" to be submitted off-chain. Then, these intents are matched and executed together in a single batch.
Because all trades are processed simultaneously, there's no opportunity for front-running - bots can't jump ahead and exploit your trade.
This process happens through a solvers network - specialized bots that compete to offer users the best execution. It's a win-win for both users and liquidity providers.
Capital Efficiency & Enhanced Yield
Traditional AMMs spread liquidity across the entire possible price range. That means your tokens might sit unused if no trades happen near their price.
CoW AMM allows LPs to concentrate their liquidity into targeted price ranges - making better use of capital and increasing the chance that they'll earn trading fees.
It works similarly to how index funds concentrate around certain market segments. That's why a CoW AMM - once new features have been deployed - acts as an "enhanced index fund" for DeFi - your funds are passively managed, but smartly deployed for better returns.
Real-Life Example: CoW AMM in Action
Let's say you want to swap 1 ETH for USDC using CoW AMM.
-
You submit an "intent to trade" - a request that says, "I want to swap 1 ETH for the best possible amount of USDC."
-
Your intent goes into a batch with many others.
-
CoW Protocol's solver network analyzes the best path for execution - across multiple pools, DEXs, or even aggregators.
-
The batch is executed, and you receive your USDC - with less slippage, no MEV, and often a better price than on a traditional AMM.
As a result, users trade with confidence, and LPs see better yields.
Why This Matters (Especially for Beginners)
CoW AMM's design brings professional-level optimization to everyday users. You don't need to understand complicated strategies or monitor the markets constantly. Just deposit tokens, or trade when you need to - and the system handles the rest with fairness and efficiency.
For beginners, this means:
-
No need to worry about front-running or being "gamed"
-
Easier, smoother trades with better pricing
-
A safer and more welcoming introduction to DeFi
Traditional Market Makers vs. AMMs vs. CoW AMM
Final Thoughts: The Future of AMMs
Automated Market Makers are one of the pillars of decentralized finance. They've allowed people to trade without centralized exchanges, earn passive income through liquidity provision, and create more open financial systems.
But as with any technology, innovation is key.
CoW AMM represents a next-generation evolution of this idea - one that's more secure, more capital efficient, and more user-friendly. By solving key problems like MEV and improving how liquidity is deployed, CoW DAO is helping build a DeFi ecosystem that truly works for everyone.
Whether you're a beginner exploring DeFi for the first time or a seasoned user looking for better tools, AMMs - and especially CoW AMM - are worth your attention.
