An automated market maker, or AMM, is a robot that is always willing to quote you a price between two assets. Uniswap uses a simple formula, while Curve, Balancer, and others employ more sophisticated ones.
An AMM enables you to both trade without trust by providing liquidity to a liquidity pool or become the house by trading on your own. In other words, anyone can become a market maker on an exchange and earn fees by providing liquidity.
AMMs have become popular in the DeFi sphere owing to their ease of use. Market making in a decentralized economy is a key component of the crypto vision.
Introduction
There has been an increase in interest in Decentralized Finance (DeFi) on Ethereum and other smart contract platforms like BNB Smart Chain.
Yield farming has become a popular method of token distribution, tokenized BTC is growing on Ethereum, and flash loan volumes are booming.
Competitive volumes, high liquidity, and an increasing number of users are all signs of a healthy automated market maker protocol like Uniswap.
How does this exchange work? Why is it so quick and simple to set up a market for the latest food coin? Can AMMs truly compete with conventional order book exchanges? Let’s find out.
What is an Automated Market Maker?
Automated market makers (AMMs) are a form of decentralized exchanges (DEXs) in which assets are priced using mathematical formulas rather than an order book.
Instead of using an order book like a traditional exchange, an asset’s price is determined by a pricing algorithm.
The formula behind Uniswap’s protocol is x * y = k, where x is the amount of one token in the liquidity pool and y is the amount of the other. The k in this formula is a constant and denotes that the pool’s total liquidity always stays the same.
Other AMMs that target specific use cases will use different formulas. They all, however, price according to an algorithm. If this is unclear to you right now, don’t fret; it will all make sense in the end.
Market makers usually work with firms that have large resources and complex strategies. Market makers at an order book exchange such as Binance help you get a good price and a tight bid-ask spread. On a blockchain, market makers decentralize the process and let essentially anyone create a market. Let’s find out how.
We recommend you watching the following video before continuing reading our article:
How does AMM work?
With an AMM, you can make a trade without having a counterparty (another trader) on the other side. For example, you can buy or sell ETH using DAI. Instead, you interact with a smart contract that ‘makes’ the market for you.
Through a peer-to-peer (P2P) trade on Binance DEX, users directly trade between their wallets. When you trade BNB for BUSD on Binance DEX, someone else is buying BNB with their BUSD on the other side of the trade.
When we say P2P, we mean peer-to-peer.
Traditional financial markets are peer-to-peer (P2P), but in contrast, an AMM is peer-to-contract (P2C). Because there is no order book, there are no order types on an AMM.
When you want to buy or sell an asset, the price you get is determined by a formula rather than an order book. Some future AMM designs, however, may counteract this restriction.
No, there still needs to be a market created, but counterparties are no longer necessary. Correct.
Users called liquidity providers (LPs) still provide the liquidity in smart contracts.
What is a liquidity pool?
Traders can trade against a liquidity pool, which is a pile of funds with which liquidity providers (LP) deposit funds. LPs earn fees from the trades that take place in their pools by providing liquidity to Uniswap, for example, depositing 50% ETH and 50% DAI into the ETH/DAI pool.
In Uniswap v2, LP reward is determined by the protocol. It’s quite simple to add funds to a liquidity pool. Anyone can become a market maker? Yes! The rewards are determined by the protocol.
For example, Uniswap v2 charges 0.3% on trading fees, which is directly distributed to LPs. Other platforms or forks may charge less in order to attract more liquidity providers to their pools.
Why is liquidity important when seeking to capture large orders? Because AMMs function by aggregating orders and then splitting them up among multiple market participants, the elimination of slippage resulting from high liquidity in the pool may result in increased volume on the platform.
It is important to note that the amount of slippage associated with different AMM designs will vary. Pricing is determined by an algorithm. The tokens in the liquidity pool are tallied after a transaction, and the algorithm determines the price. If there is a significant change in the token ratio, there will be a lot of slippage.
If you wanted to purchase all of the ETH in the ETH/DAI pool on Uniswap, you wouldn’t be able to! The premium would be higher and higher for each additional ETH, yet you still would not be able to get all of it from the pool. Why? Because of the formula x * y = k. If either x or y is zero, indicating there is no ETH or DAI in the pool, the equation does not function.
There is, however, more to be aware of about AMMs and liquidity pools. You must keep in mind one thing else when providing liquidity to AMMs—impermanent loss.
What is an impermanent loss?
An impermanent loss occurs when the price ratio of the tokens you deposited in the pool changes after you deposited them. The higher the change, the greater the impermanent loss. AMMs work best with token pairs that have a similar value, such as stablecoins or wrapped tokens. If the price ratio between the pair remains in a relatively small range, impermanent loss is also low.
A lot of change in the proportion might cause liquidity providers to be better off holding tokens instead of contributing to a pool.
Even so, pools such as ETH/DAI that are quite sensitive to fleeting losses have been profitable due to the trading fees they gain.
It’s unfortunate that this phenomenon isn’t named “impermanence” since it doesn’t mitigate permanent losses if the assets revert to their original deposit price.
However, if you withdraw your funds at a different price ratio than you deposited them, the losses will still be significant. While trading fees might mitigate losses in some instances, they are still important to consider.
It is important to be vigilant when depositing funds into an AMM, so make sure you understand the consequences of permanent loss. For more information on impermanent loss, read Pintail’s article.
Closing thoughts
Anyone can create a DeFi market using automated market makers. Despite their shortcomings when compared to order book exchanges, these systems are popular in the DeFi space for their seamless and efficient functionality.
Despite their infancy, AMMs are already quite popular.
The current crop of Uniswap, Curve, and PancakeSwap AMMs are visually appealing but technologically limited. We might expect to see many new AMM designs in the future, which will likely result in lower fees, less friction, and therefore better liquidity for all DeFi users.
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