It can take a while to understand how everything works in the crypto industry. This can certainly be the case for crypto trading, as a number of different essential tools and additional features are used in the process. One such tool, an Automated Market Maker (AMM), is now used daily by traders to execute transactions.
But what is an Automated Market Maker and can it be useful to you?
What is an Automated Market Maker (AMM)?
One of the main desires of many cryptocurrency owners is trustless trading. Unfortunately, third parties and central authorities can be problematic and time-consuming in finance, so decentralized financial services (DeFi) are designed to eliminate these problems. This is where automated market makers come in handy.
An automated market maker is a digital tool or protocol used to facilitate trustless crypto transactions, i.e. without a third party. Although not used by all cryptocurrency exchanges, they are used by all decentralized cryptocurrency exchanges (DEX). However, many major crypto exchanges today, such as Coinbase and Kraken, do not use a decentralized model, which may be offensive to some, since the whole idea of ​​cryptocurrency is largely based on decentralization.
So if you want to use a fully decentralized exchange, you will come into contact with an automated market maker.
The first decentralized exchange to launch a successful automated market maker was Uniswap, which exists on the Ethereum blockchain. Since launching in 2018, automated market makers have become far more common in the DeFi realm.
You won’t find an automated market maker anywhere outside of the DeFi industry. They are essentially an alternative to the typical order books used by regular exchanges. Instead of one user offering a price to buy an asset from another user, AMMs jump in and price the assets as accurately as possible. So how does this work?
How does an automated market maker work?
Automated market makers rely on mathematical formulas to price assets automatically without human intervention. Liquidity pools play another key role in this process.
On a crypto exchange, a single liquidity pool contains a large pile of assets locked in a smart contract. The main purpose of these locked tokens is to provide liquidity, hence the name. Liquidity pools require liquidity providers (ie asset providers) to create a market.
These liquidity pools can be used for a variety of purposes, such as yield farming and borrowing or lending.
Within liquidity pools, two different assets come together to form a trading pair. For example, if you’ve seen two asset names next to each other separated by a slash (like USDT/BNB, ETH/DAI) on a decentralized exchange, then you’re looking at a trading pair. These example pairs are ERC-20 tokens on the Ethereum blockchain (like most decentralized exchanges).
The ratio of the amount of one asset to another in a trading pair does not have to be equal. For example, a pool could have 80% Ethereum and 20% Tether tokens, giving a total ratio of 4:1. But pools can also have similar conditions.
Anyone can become a market maker by inserting the preset ratio between two assets in a trading pair into the pool. Traders can trade assets against the liquidity pool rather than directly with each other.
Different decentralized exchanges can use different AMM formulas. Uniswap’s AMM uses a fairly simple formula, yet it has been very successful. In its most basic form, this formula presents itself as “x * y = k”. In this formula, “x” is the amount of the first asset in a liquidity pool and trading pair, and “y” is the amount of the second asset in the same pool and pair.
With this particular formula, any given pool using AMM must maintain the same total liquidity on a constant basis, meaning the “k” in this equation is a constant. Other DEXs use more complicated formulas, but we won’t get into them today.
The benefits of automated market makers
As previously discussed, AMMs can cut out the middleman and make trading on DEXs completely trustless, a valuable element for many crypto holders.
AMMs also give users an incentive to provide liquidity in pools. If a person provides a given pool of liquidity, they can earn a passive income via the transaction fees of other users. This financial lure is why liquidity providers are so numerous on DEXs.
Because of this, AMMs are responsible for bringing liquidity to an exchange, which is really their bread and butter. So on a DEX, AMMs are essential.
In addition, liquidity providers can also benefit from yield farming via AMMs and liquidity pools. Yield farming involves a person leveraging their crypto to receive liquidity pool assets in return to provide liquidity. Providers can also move their assets between pools to maximize returns. These returns usually come in the form of an annual percentage yield (APY).
The Disadvantages of Automated Market Makers
While AMMs are very useful, they can give way to certain drawbacks, including slippage, which occurs when there is a difference between the estimated price of an order and the price of the order that ends up being executed. This is reduced by increasing the amount of liquidity in a given pool.
On top of this, AMMs and liquidity pools are also associated with permanent loss. This involves the loss of funds via volatility in a trading pair. This volatility refers to the price of one or both assets in the pair. If the value of the assets on withdrawal is lower than it was on deposit, the holder has suffered a permanent loss.
Permanent losses are a common problem throughout DEXs, as cryptocurrencies are volatile and unpredictable by nature. In some cases, however, an asset will recover from the drop in price, which is why this type of decline in value is known as “infinite”.
Automated market makers keep DeFi moving
Although automated market makers can be very useful in DEXs, they certainly pose certain risks to traders and investors. This is why it is always important to understand which DeFi service you want to use before putting in any of your money. That way, you can prepare as much as possible for unexpected price drops or crashes.
