Cryptocurrency has undoubtedly been one of the most powerful technological innovations in recent years, with a particular focus on decentralization. It has made it possible to conduct financial transactions between two parties without the use of middlemen, allowing for the exchange of assets in a trustless manner. The growth of controlled exchanges like Coinbase is to be applauded.
At the same time, the number of decentralized exchanges has increased. Surprisingly, some companies are using blockchain networks to run trading venues and are rewarding users for supplying liquidity. Automated Market Makers, or AMMs, are such platforms, and they play a significant part in the burgeoning DeFi ecosystem. The following discussion explains what an automated market maker is and how they work in detail.
What are Automated market makers (AMM)?
In order to learn about Automated market makers, we first need to grasp the concept of traditional market makers.
Traditional market makers
Market makers provide liquidity in traditional markets such as gold, oil, and stocks, allowing investors to sell or buy assets at prices near the publicly posted price. A market maker’s job is to link a buyer with a seller. For the execution of a trade, it is critical to ensure that the purchase order and sell order are identical. A method like this can be compared to the order book paradigm, in which all orders are kept in a book. The order book exchange is a tried and true method for global finance, involving several market makers and a large number of participants.
Consider the following scenario in the context of cryptocurrency. If you want to sell a token, a typical market maker will find a buyer for you. On the other hand, if investors desire to acquire a token, the market maker should locate buyers for the token. In the traditional financial industry, large financial companies and institutions have traditionally served as market makers. Traditional market makers showed a high level of risk tolerance when it came to buying and selling assets. Traditional market makers charged a fee for each asset they covered in order to mitigate such risks.
When smart contracts are involved, however, the usual market-maker process takes a long time. Automated Market Makers are, without a question, an unavoidable requirement in such settings.
Automated market makers
Now that you know what a market maker performs, you might be interested in learning more about an automated market maker. The goal of decentralized exchanges is to eliminate all intermediary processes related to cryptocurrency trading. Custodial infrastructure and order matching systems are not supported by DEXs. As a result, DEX users have a great deal of autonomy when it comes to conducting transactions directly from their non-custodial wallets. The replacement of order matching systems and the order book architecture with autonomous protocols known as “Autonomous Market Makers”, or AMMs, is the most intriguing feature of decentralized exchanges.
In its most basic form, an AMM (automated market maker) is a protocol, algorithm, or formula that assists in the pricing of assets. The automated market maker algorithm assists in asset pricing rather than using an order book approach like traditional exchanges. It’s also worth noting that the AMMs formula may vary depending on the methodology.
In the case of Uniswap, the automated market maker formula is “x * y = k” The amount of a particular token in the liquidity pool is represented by “x” whereas the quantity of another token in the liquidity pool is represented by “y” The letter “k” in the Uniswap automated market maker formula denotes a fixed constant in the equation. The fixed constant ‘k’ indicates that the pool’s overall liquidity should always be the same.
Interestingly, depending on their specific target use cases, another AMM may use a different automated market maker algorithm. On the other hand, all AMMs have one major feature in common: they all use algorithms to determine asset prices. AMMs could aid in the decentralization of the process of obtaining good crypto-asset values, allowing anyone to construct their own market on a blockchain network. Curve, Uniswap, and Balancer are some of the most well-known AMM crypto exchanges.
How does an Automated Market Maker(AMM) work?
The working of AMMs is the next crucial part of a guide on automated market maker explained adequately. Before learning how AMMs work, you should be aware of two key features.
- Individual ‘liquidity pools’ with AMMs contain the trading pairs that would normally be found on a centralized exchange.
- Furthermore, by depositing assets represented in the pool, any individual could provide liquidity to the individual pools. For example, to become a liquidity provider, you must deposit a certain amount of ETH and USDT into an ETH/USDT pool.
Getting to the bottom of the question “How do automated market makers work?” You should be aware that they function similarly to an order book exchange. The liquidity pool, on the other hand, contains trading pairs like ETH/DAI and ETH/USDT. You don’t need another trader to complete a transaction, though, because you can engage with a smart contract that creates or “makes” the market. Trades take place directly between user wallets on decentralized exchanges like Binance DEX.
If you’re selling BNB for BUSD on the Binance DEX, someone on the other end of the transaction is buying BNB with the BUSD they have. A peer-to-peer transaction is a term used to describe this type of transaction. The fact that AMMs are peer-to-contract or P2C, on the other hand, provides an easy response to the question “How do automated market makers work?” Transactions in automated market makers do not require any counterparties, as they do in traditional transactions. AMM transactions, on the other hand, are carried out between users and smart contracts. It’s also worth noting that, due to the lack of an order book, you won’t be able to discover any order types on an AMM crypto exchange.
Liquidity pool – a central factor
The most noticeable feature of Automated Market Makers, or AMMs, is that buyers and sellers on DEXs do not have to wait for counterparties to sell or buy crypto. However, some agents must be in charge of establishing the market. Liquidity is still required in the smart contract, which allows for trade on AMMs without the use of counterparties. Liquidity providers save the day by providing the liquidity that the smart contract requires.
Adding funds to liquidity pools is how liquidity providers work. Liquidity pools are essentially large sums of money that dealers can trade with. For supplying liquidity in the automated market maker algorithm, liquidity providers might earn a portion of the fees from trades that occur in their pool. For obvious reasons, liquidity providers are one of the most significant parts in answers to the question “How do automated market makers work?”. Liquidity providers in Uniswap, for example, would be required to deposit the equivalent of two tokens in the ETH/DAI pool. As a result, it is clear that anyone can become a market maker by contributing funds to a liquidity pool. The benefits for liquidity providers are determined by the automated market maker protocol. In the case of Uniswap v2, there is a transaction charge of 0.4 percent, which is paid to liquidity providers directly.
What is impermanent loss?
Impermanent loss is one of the dangers connected with liquidity pools. When the price ratio of pooled assets varies, this happens. An LP will automatically suffer losses when the price ratio of the pooled asset differs from the price at which the funds were placed. The greater the price change, the greater the loss incurred. Pools with variable digital assets are prone to impermanent losses.
This loss, however, is only temporary because there is a chance that the price ratio will revert. Only when the LP withdraws the funds before the price ratio reverts do the loss become permanent. Also, keep in mind that transaction fees and LP token staking can occasionally compensate for such losses.
Examples of Automated Market Maker Protocols
A discussion with a properly stated automated market maker would be incomplete without a rundown of common AMM protocols. Here’s a rundown of some of the most well-known automated market maker protocols available today.