Robots that are completely digital are often used in the trading space and that the cryptocurrency market has grown over time and includes the use of the trading bots. An automated market maker or AMM is something of the same kind. You might think of it as a robot that is always in a position to quote you the price differences between two assets. Some of the AMMS utilize a pretty simple formula just like the Uniswap while there are some others like the Balancer and Curve that indulge in the most complicated ones.
Utilizing an AMM, you can employ trustworthy trading and simultaneously, you are also eligible to offer liquidity to a liquidity pool. This essentially permits anyone to stand as a market maker on an exchange and thereby earn fees for offering the liquidity. These robots have really carved out their niches in the DeFi space owing to how simple and easy they are to use.
DeFi has seen a lot of explosion in interest on Ethereum and the other smart contract platforms such as the Binance Smart Chain. In this regard, yield farming has also become a pretty popular way of distributing tokens, the tokenized BTC is also growing on Ethereum and the flash loan volumes are also increasing. In the meantime, the automated market maker protocols such as Uniswap are regularly seeing the competitive volumes, increasing number of the users and high liquidity.
In this article, we will take you through the actual meaning of Automated Market Makers, how the exchanges work and see whether the AMMs can really compete with the traditional order book exchanges.
What Is An Automated Market Maker (AMM)?
An automated market maker or commonly termed as AMM is a kind of decentralized exchange or DEX protocol that depends on a mathematical formula for the price assets. In place of using an order book unlike the traditional exchanges, the assets are priced as per a pricing algorithm.
However, this formula might vary with each protocol. For instance, the Uniswap exchange uses the x*y=k, where x is defined as the amount of a single token in the liquidity pool while y is the amount of the other. In this formula, k has been taken as a fixed constant making sure that the total liquidity of the pool always remains the same. On the contrary, the other AMMs will utilize the other formulas designed for the specific use cases that they want to target. However, the similarity between all of them is that they determine the values algorithmically.
The traditional market making generally works with the forms possessing vast resources and the complex strategies. The market makers aid an individual to receive a good price and the tight bid-ask spread on an order book exchange such as Binance. The AMMs decentralize this process and permit essentially anyone to create a market on the blockchain.
How Does An Automated Market Maker Perform?
An AMM works just as an order book exchange that offers trading pairs. Such as ETH/DAI. You are not required to have a counterparty or other trader on the other side for conducting a trade. Instead, you are making interactions with a smart contract that creates a market for you. On a decentralized exchange such as the Binance DEX, trades occur directly between the user wallets. For example, if you are attempting to sell Binance Coin (BNB) for Binance USD (BUSD) on the Binance DEX, there will be someone on the other side of the trade attempting to purchase BNB with BUSD. This is called a peer-to-peer (P2P) transaction.
On the contrary, you can also think of the Automated Market Makers as peer-to-contract or P2C. This means that there are no requirements for the counterparties in the traditional sense as the trades occur between the contracts and the users. As there is no order book, there remains no order types on an AMM. Instead, what price you receive for an asset that you want to buy or sell entirely depends on a particular formula. Although it is worth noting that some of the future AMM designs might counteract these limitations. No requirement for the counterparties still means that someone has to create the market. The liquidity in the smart contracts still need to be provided by the users and these users are termed as liquidity providers or LPs.
What Is A Liquidity Pool?
The liquidity pools are funded by these LPs or the Liquidity providers. A liquidity pool can be determined as a huge pile of funds that the traders can usually trade against. In return for providing the liquidity to the protocol, the LPs earn fees from the trades that occur in their pool. Considering the case of Uniswap, the LPs deposit an equivalent value of both the tokens – for instance, 50% DAI and 50% ETH to the ETH/DAI pool.
Does this mean that anyone can become a market maker? Yes, of course! It is relatively easier to add funds to a liquidity pool. The rewards are then determined by the protocol. For instance, the Uniswap v2 charges the traders 0.3% that directly goes to the LPs. The forks or other platforms might charge less for attracting more liquidity providers to their pool.
Why do you think that attracting liquidity is important? Owing to the way the AMMs function, the more liquidity a pool bears, the less slippage large orders might incur. In turn, they may attract more volume to the platform. The slippage issues vary with the various AMM designs. However, this is something that you need to remember. The pricing is determined by an automated market maker algorithm. To be simple, the pricing is determined on how much the ratio between the tokens in a liquidity pool changes following a trade. If the ratio alters by a wide margin, there is going to be a large amount of slippage.
Taking this a little further, let us say that you wish to purchase all the ETH in the ETH/DAI pool on the Uniswap. But you cannot. You will have to pay an exponentially higher premium for every additional Ether. Despite this, you will not be able to purchase all the ETH from the pool. Why is it so? It is owing to the automated market maker formula x * y = k. In this case, if either the x or y is zero, meaning that there is zero DAI or zero ETH in the pool, the equation will lose its value. However, impermanent loss also plays a definite role in AMM.
What Is Impermanent Loss?
Impermanent loss occurs when the price ratio of then deposited tokens alters after you have deposited them in the pool. The larger the change will be, the bigger will be the impermanent loss. This is the reason why the AMMs work best with the token pairs that possess a similar value like the wrapped tokens or stablecoins. In case the price ratio between the pair remains within a limited range, the impermanent loss is also insignificant.
On the contrary, if the ratio varies a lot, the liquidity providers might consider holding their tokens in place of adding the funds to a pool. The Uniswap pools such as the ETH/DAI that are much exposed to the impermanent loss have been profitable owing to the accumulated trading fees.
That being said, this phenomenon seems to have been wrongly named. “Impermanence” means that in case the assets revert to the prices where they have been originally deposited, then the losses are mitigated. In contrast, if you withdraw your tokens at a different price ratio than when you have deposited those tokens, the losses incurred will be permanent. In particular cases, the trading fees might ease the losses, however, it is still important to consider the risks.
Additionally, you need to be pretty sound while depositing the funds into an AMM. You need to make sure that you understand what the Impermanent loss means and the risks that come with it.
The Variations Of The Automated Market Makers
In the original post of Vitalik Buterin, he called for the on-chain money markets or automated money markets and emphasized that the AMMS must not be the sole available option for decentralized trading. There had to be several other ways for trading the tokens as the non-AMM exchanges had been vital to retain the accurate AMM prices. However, he overlooked the development of various approaches to AMMs.
With the quick evolution of the DeFi ecosystem, there emerged three dominant models of AMM as the most prominent Automated Market Maker example viz., Uniswap, Curve and Balancer. However, the list of automated market makers also includes SushiSwap and Kyber Network.
- Uniswap: The pioneering technology of automated market maker Uniswap permits the user to create a liquidity pool bearing any pairs of the ERC20 tokens having a 50/50 ratio. It has become one of the most persistent AMM models on Ethereum.
- Curve: The platform Curve, however, specializes in curating liquidity pools of similar assets such as the stablecoins. As a result, it offers some of the lowest rates alongside the most efficient trades in the industry while solving the problem of limited liquidity.
- Balancer: It expands the limits of Uniswap by permitting the users to establish dynamic liquidity pools of upto 8 different assets in any ratio. This expands the flexibility of AMMs.
Although the Automated Market Makers reins a new technology, its iterations have already been proven as an essential financial instrument in the fast-paced evolution of the DeFi ecosystem offering a sign of a maturing industry.
Pros & Cons Of AMMs
Below are the pros and cons of AMMs at a glance.
- No KYC is required for utilizing an AMM protocol hence offers anonymity.
- As the algorithms and smart contracts control the protocols, the markets can be traded 24 hours a day.
- The AMMs and the liquidity pools eradicate the need to match the buyers with the sellers, removing the requirement for a centralized exchange.
- The AMMs are vulnerable to hacks from outsiders just like any other smart contract protocol. This might result in the loss of liquidity.
- Impermanent loss occurrence can be expected.
- All those activities that take place via the AMMs can literally increase the gas prices on the associated blockchain network.
- The arbitrage traders are needed to keep the liquidity pools balanced.
List Of AMM Coins
Below is a list of automated market maker coins. However, there are more coins and we can expect more coins to join in future.
The Automated Market Makers are the basics of the DeFi space. They essentially enable anyone to seamlessly and efficiently create markets. They too have their limitations as compared to the order book exchanges. However, they bring in overall innovation to the crypto sphere which is invaluable.
The AMMS are still in their nonage. The AMMs that we use today such as the Curve, Pancakeswap and Uniswap are designed elegantly although they possess quite limited features. We can expect more innovative AMM designs to hit the market in future. This would lead to lower fees, lesser friction and hence better liquidity for every DeFi user. You may also check the internet to find out how to create an automated market maker.