Automated Market Maker (AMM)?/ What is a liquidity pool?...

Automated Market Maker

An automated market maker (AMM) is a tool used to provide liquidity in decentralized finance (DeFi). They are used to enable the automatic trading of digital assets. They do this by using liquidity pools as a replacement for traditional buyer and seller markets.

A market maker is an individual participant or member firm of an exchange that buys and sells securities for its own account. Market makers provide the market with liquidity and depth while profiting from the difference in the bid-ask spread.

Automated market makers were initially introduced by Vitalik Buterin in 2017. Four years later, the first AMM models were launched. Not only have they severely improved the capabilities of existing decentralized exchanges, but AMMs have also made it possible for DeFi to exist in the first place.

What Is an Automated Market Maker (AMM)?

AMM is the underlying protocol used by decentralized exchanges with an autonomous trading mechanism. This eliminates the need for centralized authorities like exchanges and other financial entities. Put simply, it allows two users to transact their assets without any intermediary facilitating the exchange.

Decentralized financial markets are becoming popular because of their ability to eliminate an intermediary between transacting parties. One of the unsung heroes of this success is the automated maker protocol (AMM) within these transaction systems.

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, meaning the pool’s total liquidity always has to remain the same. Other AMMs will use other formulas for the specific use cases they target. The similarity between all of them, however, is that they determine the prices algorithmically. If this is a bit confusing right now, don’t worry; hopefully, it’ll all come together in the end.

Traditional market-making usually works with firms with vast resources and complex strategies. Market makers help you get a good price and tight bid-ask spread on an order book exchange like Binance. Automated market makers decentralize this process and let essentially anyone create a market on a blockchain. How exactly can they do that? Let’s read on.

Automated market makers

Automated market makers are a part of decentralized exchanges (DEXs) that were introduced to remove any intermediaries in the trading of crypto assets. You can think of AMM as a computer program that automates the process of providing liquidity. These protocols are built using smart contracts — a computer code that executes itself — to mathematically define the price of the crypto tokens and provide liquidity.

In the AMM protocol, you do not need another trader to make a trade. Instead, you can trade with a smart contract. So trades are peer-to-contract and not peer-to-peer. If you want to trade a particular crypto asset with another, like Ether (Ethereum’s native currency) for Tether (Ethereum token pegged to the US dollar), you need to find an individual ETH/USDT liquidity pool. As mentioned above, what price you get for an asset you want to buy or sell is determined by a mathematical formula.

In AMM, anyone can be a liquidity provider if they meet the requirements stipulated in the smart contract. So, in this example, the liquidity provider will need to deposit a pre-determined amount of Ether and Tether tokens to the ETH/USDT liquidity pool. In return for providing liquidity to the protocol, the liquidity providers can earn fees from trades in their pool.

Why is AMM important to investors?

AMM helps set up a system of liquidity where anyone can contribute to it. This removes any intermediary lowering transaction fees for investors. High liquidity is essential for healthy trading activity. If there is less liquidity, it could cause slippage. Low liquidity introduces high volatility in the prices of assets in the market.

AMMs also allows anyone to become a liquidity provider, which comes with incentives. Liquidity providers get a fraction of the fees paid on transactions executed on the pool.

How does an automated market maker (AMM) work?

An AMM works similarly to an order book exchange in that 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.

On a decentralized exchange like Binance DEX, trades happen directly between user wallets. If you sell BNB for BUSD on Binance DEX, there’s someone else on the other side of the trade buying BNB with their BUSD. We can call this a peer-to-peer (P2P) transaction.

In contrast, you could think of AMMs as peer-to-contract (P2C). There’s no need for counterparties in the traditional sense, as trades happen between users and contracts. Since there’s no order book, there are also no order types on an AMM. What price you get for an asset you want to buy or sell is determined by formula instead. Although it’s worth noting that some future AMM designs may counteract this limitation.

So there’s no need for counterparties, but someone still has to create the market, right? Correct. The liquidity in the smart contract still has to be provided by users called liquidity providers (LPs).

What is a liquidity pool?

Liquidity providers (LPs) add funds to liquidity pools. You could think of a liquidity pool as a big pile of funds that traders can trade against. In return for providing liquidity to the protocol, LPs earn fees from the trades that happen in their pool. In the case of Uniswap, LPs deposit an equivalent value of two tokens – for example, 50% ETH and 50% DAI to the ETH/DAI pool.

Hang on, so anyone can become a market maker? Indeed! It’s quite 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.

Why is attracting liquidity important?

Due to the way AMMs work, the more liquidity there is in the pool, the less slippage large orders may incur. That, in turn, may attract more volume to the platform, and so on.

The slippage issues will vary with different AMM designs, but it’s definitely something to keep in mind. Remember, pricing is determined by an algorithm. In a simplified 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.

To make this a bit further, let’s say you wanted to buy all the ETH in the ETH/DAI pool on Uniswap. Well, you couldn’t! You’d have to pay an exponentially higher and higher premium for each additional ether, but still never could buy all of it from the pool. Why? It’s because of the formula x * y = k. If either x or y is zero, meaning there is zero ETH or DAI in the pool, the equation doesn’t make sense anymore.

But this isn’t the complete story about AMMs and liquidity pools. You’ll need to keep in mind something else when providing liquidity to AMMs – impermanent loss.

What is impermanent loss?

Impermanent loss happens when the price ratio of deposited tokens changes after you deposit them in the pool. The larger the change is, the bigger the impermanent loss. This is why AMMs work best with token pairs that have a similar value, such as stable coins or wrapped tokens. If the price ratio between the pair remains in a relatively small range, the impermanent loss is also negligible.

On the other hand, if the ratio changes a lot, liquidity providers may be better off simply holding the tokens instead of adding funds to a pool. Even so, Uniswap pools like ETH/DAI that are quite exposed to impermanent loss have been profitable thanks to the trading fees they accrue.

With that said, the impermanent loss isn’t a great way to name this phenomenon. “Impermanence” assumes that if the assets revert to the prices where they were originally deposited, the losses are mitigated. However, if you withdraw your funds at a different price ratio than when you deposited them, the losses are very much permanent. In some cases, the trading fees might mitigate the losses, but it’s still important to consider the risks.

Be careful when depositing funds into an AMM, and make sure you understand the implications of impermanent loss. If you’d like to get an advanced overview of impermanent loss, read Pintail’s article about it.

In Conclusion

Computerized marketplace makers are a staple of the DeFi space. They permit basically absolutely everyone to create markets seamlessly and successfully. At the same time as they do have their obstacles as compared to ordering e-book exchanges. The general innovation they create to crypto is beneficial.

AMMs are still in their infancy. The AMMs we recognize and use today like Uniswap, Curve, and PancakeSwap are elegant in design, but quite limited in functions. There are possibly many extra progressive AMM designs coming inside the destiny. This needs to lead to lower charges, less friction, and ultimately higher liquidity for each DeFi person.

Still, got questions on DeFi and automatic market-making? check out our Q&A platform, Ask Academy, in which the Binance network will solve your questions.

However, if there is anything you think we are missing. Don’t hesitate to inform us by dropping your advice in the comment section.

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