Automated market makers (AMMs) are an increasingly popular branch of decentralized finance (DeFi), which falls within the specific subset of decentralized exchanges (DEXs). The broad goal of AMMs is to reduce the number of moving parts that facilitate cryptocurrency trades by replacing limit orders (and the resources that go into fulfilling them) with an automated approach to symbolic pricing. Sounds complicated, right? Well, it must be admitted that it is a concept that experienced crypto traders could grasp more easily than lay people. In simple terms, however, it is not beyond your comprehension.
How Do Automated Market Makers Work?
To explain how AMMs work, we first clear a couple terms.
First, ERC-20 tickets. These are tickets specifically designed for use on Ethereum blockchairs.
Next, a liquidity pool. This season has been described as “levels at which price often ‘makes a decision’ as many orders hit the market ”. You might think of a liquidity fund as the intersection between orders that ultimately determines where an asset is valued. Or, think of it as a specific asset supply, which determines the price of that asset.
Now, on to automated market makers. AMMs are platforms for cryptocurrency trading, generally built using the Ethereum blockchain and using a liquidity pool of ERC-20 tokens, as well as other types of coins. The liquidity fund that funds AMMs takes the role of limit order books in other types of exchanges. Traditionally, an exchange host would have to process buyers ‘and sellers’ orders to acquire or sell assets, then find a matching party that agrees to the terms of the termination order or sale. Not so with AMMs.
Instead, an algorithmic smart contract continuously monitors asset storage in the liquidity fund. As some tradable assets are bought in larger quantities, their supply declines and their prices rise correspondingly. As an ERC-20 token in the liquidity pool is deposited back into the liquidity pool, its availability increases and thus its price decreases. The algorithm uses these relative supplies of some tickets to determine their price in real time. Instead of issuing purchase orders or selling orders and arranging trading parties, the algorithm simply sets the price, and buyers and sellers are free to operate on the basis of that price range.
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What are the Benefits of AMMs?
The upside of automated market makers can be discussed in relation to central markets as well as decentralized exchanges (DEXs). The main advantage of AMMs over centralized alternatives is their decentralization. Rather than requiring human parties to match and process purchase orders (and possibly perform other administrative tasks required in a central exchange), smart contracts play the central role in AMMs.
Generally speaking, there are many benefits to devolved governance. They include:
- Fewer middle men
- Less opportunity for human grift
- Fewer parties justify their efforts by extracting value from the product (oftentimes means the consumer)
Some “decentralized” forms of cryptocurrency exchange are only partial, because they may have some features of devolution but ultimately have a centralized system of governance. For example, an exchange can outsource the processing of purchase and sale orders to human beings in the name of convenience, or it may have a centralized human board of directors. With AMMs, devolution reigns to a considerable extent (though the exact arrangement of each AMM must be evaluated individually). The very act of placing smart algorithmic contracts at the heart of pricing and order implementation demonstrates the decentralized nature of AMMs.
So what are the benefits of this devolution, in real world terms? They are:
- Pricing, because it is mathematically determined, can be set in great detail (see Uniswap Explanation how it values assets)
- Total AMM liquidity can be set, which maintains some price predictability for buyers and sellers
- There is no need for third parties between trading partners, as the contract deals with the carrying out of trades
- AMMs represent an efficient, straightforward way to trade cryptocurrency (in theory at least, because every AMM is different)
Another feature of AMMs is that those willing to provide liquidity to these markets can do so, taking home some extra coin for their service.
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How Are AMM Benefit Liquidity Providers Provided?
You may now understand that liquidity is essential to allow AMMs to work. Without assets in the coffers, the entire operation collapses—Specific contracts cannot set prices (based on the liquidity of certain assets) or perform trades if there are no assets to trade. So where does liquidity in these automated markets come from? In short, it comes from liquidity providers (LP). Different types of AMM may vary to varying degrees on liquidity providers, but they are important in every case.
Liquidity providers have a clear incentive to provide assets to the fund: fees, and possibly interest. Generally, LP can receive a portion of trading fees in exchange for providing liquidity to the market.
In general, the crypto assets that LP provides serve two purposes:
- Reduce the amount of “slippage”, or the difference between the projected price of an algorithm and the actual price of an executed trade, which may be due to sudden and sudden changes in supply
- To provide liquidity for carrying out trades
These LPs provide an essential service to AMMs, and can generally do well for doing so. However, there is a risk of pledging their assets to markets, as negative changes in the value of their tokens due to market forces in a particular AMM could result a phenomenon known as imperfect loss.
What is the Future of AMMs?
Currently, the four big fish in AMM are Uniswap, Kyber, Bancor, and Curve. These have proven to be viable methods for cryptocurrency trading, and appear to be an integral part of the growing decentralized finance (DeFi) sector. There is obvious appeal in AMMs. Namely, the ability to create a largely self-regulating market for cryptocurrency exchanges has significant appeal for those who hate middle men.
There are challenges too. Only one of those challenges is attracting and maintaining the support of liquidity providers. As trust in previous financial systems inherits, the future of AMM may become clearer. Will these automated markets become more popular, and therefore sustainable, or will the challenges be too great to achieve longevity?