Automated market makers were among the first decentralized finance applications and are still among the most well-known DeFi products today. In 2018, Uniswap became the first decentralized platform to effectively use an automated market maker (AMM) system when it launched.
Before then, traders could only make use of order books, which pair traders based on their bids and offers to facilitate trading on conventional centralized exchanges. This required the exchange operator to keep a price-organized list of all active buy and sell orders for each asset.
Each trading pair handled by the exchange had a corresponding order book (a pair of assets that can be traded for one another). It was an effective and popular strategy except that it required that you rely on and follow the directives of a central authority.
However, the need for more decentralized methods of exchange drove companies to the drawing table and that was the founding of Automated Market Makers.
What is an Automated Market Maker (AMM)?
Simply put, an Automated Market Makers (AMMs) is a decentralized exchange (DEX) protocol that uses formulas to determine the price of assets. Where centralized exchanges like Binance value assets using an order book, Automated Market Makers use a pricing algorithm. Platforms that use AMMs automated cryptocurrency trading and make it fully decentralized through the use of smart contracts and deft tokenomics.
Users essentially trade against the liquidity locked within smart contracts, not the counterparties, as is traditionally the case. Liquidity pools are a common name for these smart contracts.
It should be noted that in conventional exchanges, the position of a liquidity provider is only open to Businesses or the affluent. However, with AMMs, any entity that satisfies the conditions programmed into the smart contract is eligible to become a liquidity provider. Uniswap, Balancer, SushiSwap, and PancakeSwap are a few examples of AMMs.
How do Automated Market Makers work?
An AMM's primary goal is to guarantee that users can always trade cryptocurrency, even in the absence of counterparties with matching offers. Because of this, AMMs do not rely on order books to set up trading pairs. Instead, they use smart contracts to manage unique crypto asset pools created especially to supply the liquidity required to support frictionless trading.
For example, when trades take place on a decentralized exchange like Kraken, it is directly between user wallets. In other words, if you sell BTC for ETH or SOL, there is a buyer of ETH using BTC on the other side of the exchange. This transaction can be described as peer-to-peer (P2P).
AMMs, on the other hand, might be thought of as peer-to-contract (P2C). Since trades take place between users and contracts, counterparties in the conventional sense are not required. There is nothing like order types on an AMM because it doesn’t use order books. Instead, a formula determines the price you will receive for an asset you want to buy or sell. Though it's important to note that some potential AMM designs in the future might overcome this restriction.
Furthermore, what are called trading pairs on centralized exchanges exist on DEXes as Individual "liquidity pools". For instance, you would need to locate a BTC/ETH liquidity pool if you wanted to exchange Bitcoin for Ether. AMMs employ predetermined mathematical calculations to ensure that the ratio of assets in liquidity pools is as balanced as possible and to get rid of inconsistencies in the pricing of pooled assets.
For instance, top DeFi exchange protocol, Uniswap, and many other DeFi systems establish the mathematical relationship between the specific assets maintained in the liquidity pools using the straightforward x*y=k equation.
Here, x signifies the value of Asset A, y stands for Asset B, and k remains a constant.
In essence, the liquidity pools of Uniswap always maintain a condition in which the result of multiplying the prices of Assets A and B is always the same. This guarantees that consumers can always get a quoted price for their chosen deal as long as there is enough liquidity in the pool. This leads to the next question:
What is a Liquidity Pool?
From the above definitions, it is clear that Automated Market Makers rely heavily on Liquidity pools to facilitate trade. Let us now examine what liquidity is and the process through which these DeFi Protocols maintain their liquidity.
A liquidity pool is a reserve where individuals or businesses can deposit crypto assets which will then be used to enable future transactions. Similar to how FX traders buy and sell currency pairs, liquidity pools normally accept two cryptocurrency pairs. For instance, a trader can use an AMM to sell Bitcoin (BTC) and buy Ether (ETH) from a BTC/ETH liquidity pool, and vice versa. Some liquidity pools and AMMs simultaneously manage multiple cryptocurrencies depending on the AMM and decentralized exchange.
What is a Liquidity Provider?
As mentioned earlier, centralized exchanges usually only accommodate dedicated market makers, companies, and extremely rich individuals. However, Automated Market Makers have made it possible for literally anyone to deposit assets in their liquidity pools. These individuals or business entities are called liquidity providers. With AMMs, anyone who satisfies the necessary criteria can act as a liquidity provider.
Although the specifications differ amongst liquidity pools, most smart contracts demand that you deposit a specific amount of tokens which is usually a substantial amount, typically in the form of cryptos like Ether, Bitcoin, or Binance Coin.
In turn for providing this liquidity, providers get network fees from all trading activity taking place within their liquidity pool. It's one of several ways bitcoin owners can use their holdings to generate passive income.
Notwithstanding although, passive income is always attractive to investors, there are dangers connected to contributing to liquidity pools, one of which is Impermanent loss. This occurs when the same tokens have different values within and outside of a liquidity pool. Since the price-adjusting algorithms of liquidity pools only care about maintaining a balance between the values of the assets within a pool, when the price ratio changes, the pools adjust to fit.
Withdrawing your assets from a liquidity pool when this adjustment is unfavorable can result in a loss. Of course, the loss only occurs if you remove the assets from the pool which is why it is called impermanent.
However, Keeping your assets locked in a liquidity pool for fear of impermanent loss also prevents you from taking advantage of other profitable chances.
Hence stablecoin or wrapped token pairs, as well as other token pairs with similar values, operate well with AMMs as opposed to those with larger ratio gaps. Impermanent loss is usually insignificant if the price ratio between token pairs remains within a modest range.
Just be sure you understand the concept of impermanent loss in relation to your preferred AMM before locking your funds into their liquidity pools.
Concentrated liquidity is one of the newest developments in AMM development. In fact, it is one of the hallmarks of the most recent version of Uniswap, v3. This particular feature is intended to increase the effectiveness of the price-adjusting process, reduce slippage, and enable liquidity providers to charge larger fees.
With concentrated liquidity, Liquidity Providers can allocate assets to particular price points. Liquidity Providers can design unique price curves that suit their preferences by combining various concentrated liquidity positions. Additionally, this enables them to get trading commissions based on the liquidity offered at particular price ranges rather than the liquidity of the entire pool.
Constant Product Formula
The Constant product formula is a mathematical formula introduced by Ethereum founder Vitalik Buterin which is as follows:
tokenA_balance(p) * tokenB_balance(p) = k
Uniswap later adapted it to the more popular x * y = k formula
In practice it works like this; token price in a liquidity pool is determined by the constant, "k," which denotes a constant asset balance. In an ETH/BTC Liquidity pool, the price of ETH increases every time it is purchased since there is less ETH in the pool than there was before the purchase while the corresponding BTC in the pool decreases in price. In contrast, when more ETH is added to the pool, the price of BTC increases.
This allows the pool to maintain a steady balance where the combined value of ETH and BTC in the pool is always equal. In the end, whatever the level of price volatility, there will eventually be a return to a condition of equilibrium that reflects a fairly accurate market price. The strategy encourages traders to profit from price discrepancies between the AMM and other crypto exchanges until it is balanced again if the AMM price strays too far from market pricing on other exchanges.
Automated Market Maker Variations
50/50 token pair pools: This is the type of AMM operated by Uniswap. This ground-breaking technology enables users to construct a liquidity pool using any pair of ERC-20 tokens in a 50/50 ratio. It is, so far, the most reliable and oldest AMM model on Ethereum.
Multiple assets liquidity pools: Instead of having just a trading pair in one liquidity pool, some Protocols find a way to stretch it. For example the Automated Market Maker, Balancer goes one step further than Uniswap. By enabling customers to build dynamic liquidity pools of up to eight different assets in any ratio, Balancer pushes the boundaries of Uniswap and increases the adaptability of AMMs.
Similar Assets Liquidity pools: Another AMM model is the type operated by Curve where digital assets of a similar class such as stablecoins get locked in the same liquidity pool. This enables it to provide effective trades, and offer some of the cheapest deals and rates in the market while addressing the liquidity issue.
Popular DeFi Platforms Using AMM
In 2018, Uniswap, a decentralized open-source technology, was created. Uniswap, which was created using Ethereum, is still among the most widely used and liquid DEXs available. Since Uniswap is open-source, many people have sought to copy it or create their own variations of it. Two tokens make up Uniswap liquidity pools.
Curve is a well-known automated market maker (AMM) platform that provides a very effective method of exchanging tokens while preserving cheap fees and low slippage. As explained above, Curve achieves this by only allowing liquidity pools made up of similarly behaving assets, e.g., stablecoins.
SushiSwap is a DeFi protocol that is one of the more well-known forks of Uniswap. The main distinction between the two, despite the fact that they both function essentially identically, is tokenomics. The SUSHI cryptocurrency is made available by SushiSwap as an extra incentive scheme for liquidity providers.
PancakeSwap is a different version based on UniSwap. Both appear identical at first glance, however whereas PancakeSwap is designed to support cryptocurrencies developed using the Binance Smart Chain, UniSwap is built to support altcoins built using Ethereum (BSC). The number of cryptocurrencies developed on the Binance Smart chain is much lower than that of Ethereum, but those that are almost always have cheaper gas costs and faster transaction times than Ethereum, whose present network is already overloaded.
In terms of size based on all locked assets, Balancer is a smaller DeFi protocol that is rated ninth. Although Balancer's AMM is a less complex protocol, it has many more functions. For instance, Balancer allows for the liquidity pooling of up to eight different tokens. Compared to liquidity pools based just on two coins, this makes price volatility significantly lower.
The Bottom Line
Automated market makers have already demonstrated their effectiveness in comparison to centralized exchanges. Notably, trading volumes generated by Uniswap V3, Pancakeswap V2, and other platforms are already equal to or exceeding those of several prominent centralized exchanges. Furthermore, Automated Market Maker services are expected to advance in sophistication as ideas like protocol-owned liquidity and concentrated liquidity are further explored Finally, Layer 2 solution adoption will make trading on AMMs more affordable, quick, and practical.