An automated market maker (AMM) is a system that provides liquidity to the exchange it operates in through automated trading.
AMM systems took off after they were first implemented by Shearson Lehman Brothers and ATD in the early 1990s — before their invention, order books were created by humans who manually initiated trades meant to enhance the liquidity of the market.
This approach was the reason for some slippage and latency in price discovery on the markets. Furthermore, market makers were also accused of market manipulation. When introduced, AMMs solved all the issues caused by human market makers. Now, these types of systems are also being introduced in blockchain-based decentralized exchanges.
On AMM-based decentralized exchanges, the traditional order book is replaced by liquidity pools that are pre-funded on-chain for both assets of the trading pair. The liquidity is provided by other users who also earn passive income on their deposit through trading fees based on the percentage of the liquidity pool that they provide.
One decentralized exchange that has implemented an AMM is Uniswap. Uniswap is an Ethereum-based decentralized exchange which allows its users to both supply liquidity to earn passive income or exchange between various assets.