What is an automated market maker (AMM)?
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Automated market makers are in an exciting new development in the decentralized finance industry. Let's analyze how they function as well as their current status.
What is an AMM?
An automated market maker (AMM) is a decentralized cryptocurrency exchange (DEX) tool that uses pools of crypto assets to trade without an order book. Automated Market Makers are one of the earliest applications of decentralized finance and to this day are DeFi best-known products.
DEX (Decentralized Exchange), unlike centralized exchanges, seeks to eliminate the intermediate processes involved in cryptocurrency trading. They do not use order matching systems or custodial storage infrastructure (where the exchange stores all the wallets' private keys). DEX (Decentralized Exchange) encourages autonomy so that users can initiate transactions directly from wallets without control (wallets where a person controls the private key).
DEX (Decentralized Exchange) is also replacing order matching systems and order books with separate protocols called AMM. These protocols use smart contracts - self-executing computer programs - to price digital assets and provide liquidity. In this case, the protocol combines liquidity into smart contracts. Thus, users don't actually trade against counterparties (another trader) - instead, they trade the liquidity contained in the smart contracts. Such smart contracts are often referred to as liquidity pools. Examples of AMM are Uniswap, Balancer and Curve.
How does an automated market maker (AMM) work?
AMM's main goal is to ensure that users can trade cryptocurrency at all times, despite the absence of counterparties (another trader) with relevant offers. Therefore, while AMM has trading pairs, they do not rely on order books. Rather, they use smart contracts that manage special pools of crypto-assets designed specifically to provide the liquidity needed for seamless trading.
Typically, a liquidity pool consists of two crypto-assets that make up a specific trading pair, such as ETH and USDT. The value of the assets in the liquidity pool is carefully regulated to match a set mathematical formula. The most famous formula is probably a*b = c, which is the formula used by Uniswap, which is by far the leading automated market maker. In this formula, "a" is the sum of one asset, "b" is the sum of another asset, and "c" is a fixed constant. The formula ensures that the total liquidity in the pool remains constant and allows you to control the price ratio between the two assets algorithmically using smart contracts.
The principle of operation is quite simple. If a user buys ETH (paying for USDT) from the ETH-USDT liquidity pool, the number of ETH tokens in the pool decreases and the number of USDT tokens increases. This instructs the pool algorithm to adjust the price ratio between the two assets accordingly to keep the formula a * b = c. Other protocols, such as Curve Finance, apply more complex formulas, but the basic principle remains the same and ensures that if there is sufficient liquidity in the pool, users can expect to receive a quote price for the desired trade.
AMM needs liquidity to work properly. Pools with insufficient funds are prone to slippage. To reduce slippage, AMMs encourage users to contribute digital assets to liquidity pools so that other users can trade those funds. As an incentive, the protocol rewards liquidity providers (LPs) with a portion of the commissions paid on trades made in the pool.
For example, if your deposit is 1% of the liquidity held in a pool, you will receive an LP token representing 1% of the accrued commissions for transactions in that pool. If the liquidity provider wants to withdraw from the pool, they redeem their LP token and receive their share of the transaction fees.
LP can be used to enhance returns. In order to take advantage of this advantage, all you need to do is deposit the appropriate ratio of digital assets into the liquidity pool on the AMM protocol. Once the deposit is confirmed, the AMM protocol will send you LP tokens. In some cases, you can deposit these tokens in a separate lending protocol and receive additional interest.
What is the importance of attracting liquidity? According to the AMM principle, the more liquidity in the pool, the less slippage of large orders. And this, in turn, allows you to attract larger volumes to the platform, and so on.
There is something else to keep in mind when providing AMM liquidity - impermanent losses.
What is impermanent loss?
The risks associated with liquidity pools include impermanent loss. They arise when the price ratio of the combined assets fluctuates. LP will automatically incur losses when the price ratio of the combined asset deviates from the price at which it invested. At the same time, the greater the price change, the higher the losses incurred. Impermanent losses usually affect pools containing volatile digital assets.
However, this loss is impermanent, as there is a possibility that the price ratio will recover. Losses become permanent only if the LP withdraws funds before the price ratio changes to the opposite. In addition, it should be borne in mind that potential revenues from transaction fees and LP rates on tokens can sometimes cover such losses.
Exercise caution when depositing with AMM and make sure you understand the consequences of an impermanent loss.
AMMs are in their formative stages. The AMMs we know and use today, such as Uniswap, Curve, are elegant in design but very limited in functionality. In the future there will probably be many more innovative AMMs. All this should lead to lower commissions, less friction, and ultimately better liquidity for every DeFi user.
Pontem Network is a product studio working toward global financial inclusion powered by blockchains - primarily Aptos, the most scalable and safest L1 network. We are partnered with Aptos to build foundational dApps, development tools, AMMs, and more. The first dApp, LiquidSwap - the first-ever AMM for Aptos - is already available as a test version.