Automated Market Makers (AMMs) are an automatic robot that allow digital assets to be traded by using liquidity pools rather than a traditional market of buyers and sellers. The liquidity pools are supplied with crypto tokens by a constant mathematical formula. You can optimize liquidity pools for different purposes, and they are proving to be an important instrument in the DeFi ecosystem.
Uniswap, launched in 2018, was the first decentralized platform that applied automated market maker successfully. AMM is the underlying protocol that powers all decentralized exchanges. They simply eliminate intermediary techniques and the mechanism will assist the users to exchange cryptocurrencies.
This formula can vary with each protocol. For example, Uniswap and other networks use x * y = k, where x represents the amount of one token in the liquidity pool, and y denotes the amount of the other. In this formula, k is a fixed constant which means the pool’s total liquidity always has to remain the same.
How do Automatic Market Makers (AMMs) work?
There are two important things to know first about AMMs:
Trading pairs that are normally found on a centralized exchange exist as individual “liquidity pools” in AMMs. For instance, if one wants to trade ether for tether, they’ll need to find an ETH/USDT liquidity pool.
Instead of using dedicated market makers, liquidity to these pools can be provided by depositing both assets represented in the pool. For example, if one wants to become a liquidity provider for an ETH/USDT pool, they’ll need to deposit a certain predetermined ratio of ETH and USDT.
On a decentralized exchange like Binance DEX, trades take place directly between user wallets. If one sells BNB for BUSD on Binance DEX, there’s someone else on the other side of the trade buying BNB with their BUSD. This is called a peer-to-peer (P2P) transaction.
In contrast, AMMs can be considered as as peer-to-contract (P2C). There’s no need for counterparties in the traditional sense, as trades occur between users and contracts. Because there’s no order book, there are also no order types on an AMM. The price you get for an asset you want to buy or sell is calculated by a formula instead. Despite the fact that it’s worth noting that some future AMM designs may counteract this limitation.
What is a liquidity pool and the role of liquidity providers?
Liquidity providers (LPs) add funds to liquidity pools. The liquidity pool is considered as a big pile of funds against which users can trade. LPs earn fees from the trades that happen in the pool. So, LPs try attract more liquidity. Why is attracting liquidity important? Because of the way AMMs work, the more liquidity there is in the pool, the less slippage large orders may incur. Pools that are not adequately funded are susceptible to slippages. To mitigate slippages, AMMs encourage users to deposit digital assets in liquidity pools so that other users can trade against these funds. The slippage issues will vary with different AMM designs, but it’s certainly something to keep in mind. Don’t forget that, pricing is determined by an algorithm. In a minimal way, it’s determined by how much the ratio between the tokens in the liquidity pool changes after a trade. If the ratio changes by a wide margin, there’s going to be a large amount of slippage.
Automated market makers are a staple of the DeFi space. They enable essentially anyone to create markets seamlessly and efficiently. Although they have their limitations compared to order book exchanges, the overall innovation they bring to crypto is invaluable. Nevertheless, it is still in very beginning of the way and there is a long way to go.