Automated Market Maker

An Automated Market Maker (AMM) is a type of decentralized exchange mechanism that uses mathematical formulas rather than order books to price assets. In the prediction market context, AMMs allow trading on contracts without requiring a counterparty to take the opposite side of your trade — instead, a liquidity pool smart contract always stands ready to trade at algorithmically derived prices.

Early decentralized prediction markets like Augur and early versions of Gnosis used AMM mechanisms to bootstrap liquidity. The most common formula is the constant product market maker (x * y = k), where the relative prices adjust as trades occur. More sophisticated variants like LMSR (Logarithmic Market Scoring Rule) have been developed specifically for prediction markets to provide better price behavior near extreme probabilities.

The advantage of AMMs is that they enable markets with low initial liquidity and allow anyone to become a liquidity provider by depositing funds into the pool. The disadvantage is that prices can be moved significantly by large trades (high price impact), and AMMs are more susceptible to certain forms of manipulation than deep order book markets. Modern platforms like Polymarket have largely moved to central limit order book architectures for better execution quality.