What is an Automated Market Maker (AMM)?
When Uniswap launched in 2018, it became the first decentralized platform to successfully use an automated market maker.
An automated market maker (AMM) is the underlying protocol that powers all decentralized exchanges (DEX). Simply put, they are independent trading mechanisms that eliminate the need for centralized trading and related market making techniques. In this guide, we’ll explore how automated market makers work.
But first, let’s take a look at what market makers are.
What is an Automated Market Maker (AMM)?
An automated market maker (AMM) is a type of decentralized exchange (DEX) protocol that relies on a mathematical formula to price assets. Instead of using an order book like a traditional exchange, assets are priced according to a pricing algorithm.
This formula can vary with each protocol. For example, Uniswap uses x – y = k, where x is the amount of one token in the liquidity pool, and y is the amount of the other. In this formula, k is a fixed constant, which means that the total liquidity of the fund must always be the same. Other AMMs will use other formulas for the specific use cases they are targeting. However, the similarity between all of them is that they determine prices algorithmically. If this is a little confusing right now, don’t worry; hopefully, it will all become clear in the end.
Traditional market makers usually work with companies with large resources and complex strategies. Market makers help you get a good price and a tight bid-ask spread on an order exchange like Binance. Automated market makers decentralize this process and allow virtually anyone to create a market on a blockchain.
How Does An Automated Market Maker (AMM) Work?
An AMM works similar to an exchange order book where there are trading pairs – for example, ETH/DAI. However, you don’t need to have a counterparty (another trader) on the other side to make a trade. Instead, you interact with a smart contract that “makes” the market for you.
In a decentralized exchange, trades are made directly between users’ wallets. If you sell BNB for BUSD on Binance DEX, there is someone else on the other side of the trade who buys BNB with their BUSD. We can call this a peer-to-peer (P2P) transaction.
Similarly, one could think of AMMs as peer-to-contract (P2C). There is no need for counterparties in the traditional sense, as trades are between users and contracts. As there is no order book, there are also no order types in an AMM. The price you get for an asset you want to buy or sell is determined by a formula. Although it is worth noting that some future AMM designs can counteract this limitation.
What is a Liquidity Pool?
Liquidity providers (LPs) add funds to liquidity pools. A liquidity pool can be thought of as a large pool of funds that traders can trade with. In exchange for providing liquidity to the protocol, liquidity providers earn commissions from trades made in their pool. In the case of Uniswap, LPs deposit a value equivalent to two tokens – for example, 50% ETH and 50% DAI to the ETH/DAI pool.
So can anyone become a market maker? Yes, that’s right. It is fairly easy to add funds to a liquidity pool. The rewards are determined by the protocol. For example, Uniswap v2 charges traders 0.3% that goes directly to LPs. Other platforms or forks may charge less to attract more liquidity providers to their pool.
What is Impermanent Loss?
Impermanent loss occurs when the price ratio of deposited tokens changes after they are deposited into the pool. The greater the change, the greater the impermanent loss. Therefore, AMMs work best with pairs of tokens that have similar value, such as stablecoins or wrapped tokens. If the price ratio between the pair remains in a relatively small range, the impermanent loss is also negligible.
AMMs or automated market makers are a staple of the DeFi space. They allow anyone to create markets seamlessly and efficiently. While they have their limitations compared to order book exchanges, the overall innovation they bring to cryptocurrency is invaluable.
AMMs are still in their infancy and are somewhat limited in their features. It is likely that there will be many more innovative AMM designs in the future. This should lead to lower fees, less slippage and ultimately better liquidity for all DeFi users.