What is an Automated Market Maker (AMM) in Crypto?

It may take some time to understand how everything works in the crypto industry. This can certainly be the case for crypto trading, as a number of essential tools and additional features are used in the process. One such tool, an automated market maker (AMM), is now used daily by traders to place trades.

But what is an automated market maker and can it help you?

What is an Automated Market Maker (AMM)?

One of the main desires of many cryptocurrency holders is to trade without trust. Unfortunately, third parties and central authorities can be problematic and time-consuming in finance, so decentralized finance (DeFi) services are designed to eliminate these issues. This is where automated market makers come in handy.

An automated market maker is a digital tool or protocol used to facilitate trustless crypto transactions, i.e. without third parties. Although not used by all cryptocurrency exchanges, they are used by all decentralized cryptocurrency exchanges (DEXs). However, many major crypto exchanges today, such as Coinbase and Kraken, do not use a decentralized model, which may be off-putting to some, as the whole idea of ​​cryptocurrency is largely based on decentralization.

So, if you want to use a completely decentralized exchange, you will come into contact with an automated market maker.

The first decentralized exchange to launch a successful automated market maker was Uniswap, which exists on the Ethereum blockchain. Since its launch in 2018, automated market makers have become much more common in DeFi.

You won’t find an automated market maker anywhere outside of the DeFi industry. They are essentially an alternative to the typical order books used by regular exchanges. Instead of one user bidding a price to buy an asset from another user, AMMs step in and price assets as accurately as possible. So how does it work?

How does an automated market maker work?

Automated market makers rely on mathematical formulas to automatically price assets without human intervention. Liquidity pools play another key role in this process.

On a crypto exchange, a single liquidity pool contains a large pile of assets locked in a smart contract. The main purpose of these locked tokens is to provide liquidity, hence their name. Liquidity pools require liquidity providers (i.e. asset providers) to create a market.

These liquidity pools can be used for several purposes, such as yield farming and borrowing or lending.

Within liquidity pools, two different assets come together to form a trading pair. For example, if you saw two asset names next to each other separated by a slash (like USDT/BNB, ETH/DAI) on a decentralized exchange, then you are looking at a trading pair. These sample pairs are ERC-20 tokens on the Ethereum blockchain (like most decentralized exchanges).

The ratio of the amount of one asset to another in a trading pair need not be equal. For example, a pool might contain 80% Ethereum and 20% Tether tokens, giving an overall ratio of 4:1. But pools can also have equal ratios.

Anyone can become a market maker by depositing the predefined ratio of two assets within a trading pair into the pool. Traders can trade assets against the liquidity pool instead of directly with each other.

Different decentralized exchanges may use different AMM formulas. Uniswap’s AMM uses a fairly simple formula, but it’s been very successful nonetheless. In its most basic form, this formula looks like “x*y=k”. In this formula, “x” is the amount of the first asset in a liquidity pool and trading pair, and “y” is the amount of the other asset in the same pool and trading pair.

With this particular formula, any given pool using MA must maintain the same total liquidity on a constant basis, which means that the “k” in this equation is a constant. Other DEXs use more complicated formulas, but we won’t go into that today.

The Benefits of Automated Market Makers

As stated earlier, AMMs can eliminate the middleman and make trading on DEXs entirely trustless, a valuable feature for many crypto holders.

AMMs also offer users an incentive to provide liquidity in pools. If an individual provides liquidity to a given pool, they can earn passive income through other users’ transaction fees. This financial lure explains why there are so many liquidity providers on DEXs.

For this reason, AMMs are responsible for bringing liquidity to an exchange, which is really their bread and butter. Thus, on a DEX, the AMMs are crucial.

Additionally, liquidity providers can also benefit from yield farming through AMMs and liquidity pools. Yield farming involves a person leveraging their crypto to receive assets from the liquidity pool in exchange for providing liquidity. Providers can also move their assets between pools to maximize their returns. These returns are usually in the form of an annual percentage yield (APY).

The Disadvantages of Automated Market Makers

Although MAs are very useful, they can give way to some disadvantages, including slippage, which occurs when there is a difference between the predicted price of an order and the price of the order that ends up being filled. . This is mitigated by increasing the amount of liquidity in a given pool.

In addition to this, AMMs and liquidity pools are also associated with impermanent losses. It involves the loss of funds through volatility within a trading pair. This volatility refers to the price of one or both assets in the pair. If the value of the assets at the time of withdrawal is lower than it was at the time of deposit, the holder has suffered a temporary loss.

Impermanent loss is a common problem in all DEXs, as cryptocurrencies are volatile and unpredictable by nature. However, in some cases an asset will recover from its fall in price, which is why this type of loss in value is called “impermanent”.

Automated market makers make DeFi work

Although automated market makers can be extremely useful within DEXs, they certainly present certain risks for traders and investors. This is why it is always important to understand the DeFi service you want to use before putting your funds forward. This way, you can prepare as much as possible for unexpected price drops or crashes.

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