Market Making in traditional finance:
- Most exchanges maintain an order book and facilitate matches between buyers and sellers.
- For each successful match, traders are charged exchange fees which go directly to exchange operators.
The DeFi Difference:
- Smart contracts hold liquidity reserves of various tokens, and trades are executed directly against these reserves.
- Prices are set automatically using the constant product market maker mechanism, which keeps overall reserves in relative equilibrium.
- Reserves are pooled between a network of liquidity providers who supply the system with tokens and receive a proportional share of transaction fees accrued.
IMPORTANT NOTE: With fluctuating prices, liquidity providers may incur 'impermanent loss'