What Is an Automated Market Maker (AMM)?

Introduction

Decentralized finance (DeFi) is gaining popularity among users on Ethereum and other smart contract platforms. Liquidity mining has become a popular method for token distribution, while tokenized Bitcoin on Ethereum continues to develop, and the volume of flash loans is on the rise.

At the same time, automated market maker (AMM) protocols like Uniswap are demonstrating competitive trading volumes and high liquidity, with a growing number of users.

What is an Automated Market Maker (AMM)?

An automated market maker is a decentralized exchange (DEX) protocol that prices assets through mathematical formulas. Unlike traditional trading platforms that rely on order books, AMMs use pricing algorithms to determine the value of assets.

Different protocols utilize various pricing formulas. For example, Uniswap employs the formula x * y = k, where x represents the amount of one token in the liquidity pool, y represents the amount of another token, and k is a constant that signifies the total liquidity in the pool must remain unchanged. Other AMMs may use different formulas based on specific needs, but the pricing process is always algorithmic. If you still have questions about this, keep reading, as we will explain in more detail later.

Traditional market making mechanisms typically apply to companies with ample resources and complex strategies. Using this approach, you can achieve favorable trade prices and enjoy lower spreads on order book trading platforms like Binance. Automated market makers (AMMs) decentralize this process, allowing anyone to create a market on the blockchain. So how do they accomplish this? Read on for more details.

How Do Automated Market Makers (AMMs) Work?

The operation of automated market makers (AMMs) is similar to traditional order book trading platforms; both set trading pairs (e.g., ETH/DAI). However, AMMs do not require interaction with a specific counterparty (another trader). In the AMM mechanism, traders interact with smart contracts to "create" a market.

On decentralized trading platforms like Binance DEX, trades occur directly between users' wallets. For example, if you sell BNB for BUSD on Binance DEX, another customer is effectively buying BNB with BUSD. This is known as peer-to-peer (P2P) trading.

In contrast, AMMs can be viewed as point-to-contract (P2C) trading. In this mechanism, users trade directly with the contract, eliminating the need for traditional counterparties. AMMs do not use order books, so there are no order types, and the actual buying and selling prices of assets are determined by the formula. It is worth noting that future AMM designs may gradually overcome this limitation.

Although AMMs do not set counterparties, there still needs to be a means of creating trading markets. Indeed, the liquidity within smart contracts must be provided by liquidity providers (LPs).

What is a Liquidity Pool?

A liquidity pool is a collection of funds injected by liquidity providers (LPs). You can think of it as a large pool of capital that traders can use for transactions. In return, liquidity providers earn fees from the trades that occur within the pool. For example, in the Uniswap liquidity pool, liquidity providers are required to deposit two equivalent tokens, such as contributing 50% ETH and 50% DAI to the ETH/DAI pool.

So, can anyone become a market maker? Absolutely! Injecting funds into a liquidity pool is quite straightforward, and the rewards are determined by the protocol. For instance, Uniswap v2 charges traders a 0.3% fee, which is directly distributed to liquidity providers. Other platforms or their forks may also introduce various incentives to attract more liquidity providers.

Why is attracting liquidity so important? Based on the AMM operating mechanism, the larger the liquidity in the pool, the smaller the slippage incurred by large orders. This, in turn, can attract higher trading volumes and numerous other advantages.

The issue of slippage can vary depending on the design of the AMM, but it certainly should not be overlooked. Remember, pricing is determined by an algorithm. Simply put, the pricing depends on the change in the ratio of tokens in the liquidity pool after a trade is executed. If the change is significant, it can lead to substantial slippage.

To elaborate, suppose you want to buy all the ETH in the ETH/DAI pool on Uniswap. Is that possible? The answer is no! Each additional ETH you buy requires you to pay an increasingly higher premium. Even if you are willing to pay, you cannot purchase all the ETH in the pool. Why is that? The answer lies in the equation x * y = k. If x or y becomes zero, meaning there is no ETH or DAI left in the pool, this equation loses its significance.

However, the discussion about AMMs and liquidity pools doesn't end here. There is also the consideration of impermanent loss when providing liquidity to an AMM.

What is Impermanent Loss?

Impermanent loss refers to the loss incurred when the price ratio of tokens deposited in a liquidity pool changes. The greater the change, the more severe the impermanent loss. Therefore, AMMs are best suited for token pairs with similar values, such as stablecoins or wrapped tokens. If the price ratio between token pairs remains within a relatively small range, impermanent loss can be negligible.

Conversely, if the price ratio fluctuates significantly, liquidity providers may be better off holding the tokens rather than depositing them into the pool. Even in Uniswap pools like ETH/DAI, which are susceptible to impermanent loss, users can still profit from accumulated trading fees.

However, using the term "impermanent loss" to describe this phenomenon is not entirely accurate. "Impermanent" is based on the assumption that if asset prices return to their initial deposit levels, the losses will decrease. However, if funds are withdrawn at a price ratio different from what was present at the time of deposit, impermanent loss will convert into permanent loss. In some cases, although trading fees can partially offset the loss, the risk of impermanent loss must still be considered.

Conclusion

Automated market makers are a vital component of the DeFi ecosystem, allowing anyone to efficiently create markets. While there are some limitations compared to order book trading, the innovations brought by AMMs to the cryptocurrency world are invaluable.

AMMs are still in the early stages of development. The AMMs we currently understand and utilize—such as Uniswap, Curve, and PancakeSwap—are cleverly designed but still limited in functionality. We believe that future AMM designs will incorporate more innovative technologies, enabling all DeFi users to enjoy lower fees, smoother trading experiences, and higher liquidity.

Risk Warning

While the cryptocurrency market offers significant growth potential and innovation opportunities, it also carries a high level of market risk and price volatility. The value of crypto assets can fluctuate dramatically in a short period, potentially leading to substantial financial losses for investors. Additionally, the cryptocurrency market faces multiple risk factors, including technical risks, legal and regulatory uncertainties, cybersecurity threats, and market manipulation. We strongly advise users to conduct thorough research and due diligence before making any investment decisions and to consult professional financial advisors. All investment decisions are made at the user’s own risk. Thank you for your trust and support of Venkate!

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