Automated Market Maker (AMM) is a decentralized exchange (DEX) protocol that allows users to directly trade digital assets without the need for third-party intermediaries. AMM is one of the key technologies for decentralized exchanges (DEX) and has been proven to be one of the most influential DeFi innovations, providing publicly accessible on-chain liquidity for a range of different tokens.
What is an Automated Market Maker (AMM)?
Automated Market Makers (AMMs) use algorithms to price assets in liquidity pools, enabling unstoppable, automated, and decentralized trading. It allows digital assets to be traded automatically without permission, using liquidity pools instead of traditional buy-and-sell order book markets. In traditional trading platforms, buyers and sellers provide different prices for assets. When other users find an acceptable listed price, they execute the trade, and that price becomes the market price for the asset. Stocks, gold, real estate, and most other assets rely on this traditional market structure for trading. However, AMM offers a different method of asset trading.
AMM is a unique financial tool of decentralized finance (DeFi). This new technology is decentralized, always available for trading, and does not rely on traditional interactions between buyers and sellers. This new method of exchanging assets embodies the ideals of Ethereum, crypto, and blockchain technology, where there is no single entity controlling the system, and anyone can build new solutions and participate.
Operation of Automated Market Maker (AMM)
Automated Market Maker (AMM) represents a paradigm shift in the field of decentralized exchanges (DEX), providing a unique mechanism for trading pairs like ETH/DAI without the need for traditional counterparties. Unlike centralized exchanges that match buyers and sellers based on order books, AMM operates based on point-to-contract (P2C) contracts, where trades are executed between users and smart futures, simplifying the process and eliminating the need for order types.
At the core of AMM is the liquidity pool, maintained by liquidity providers (LPs) who lock an equal amount of tokens into smart futures. This model contrasts sharply with traditional exchanges, where liquidity often comes from exchange reserves or individual market makers. AMM uses pre-programmed mathematical formulas (such as constant product market maker models) to adjust prices based on supply and ensure balance in the pool's asset ratios.
What is a Liquidity Pool?
Before AMM came into play, liquidity was a challenge for decentralized exchanges (DEXs) on Ethereum. As a complex new technology interface, it had few buyers and sellers, making it difficult to find enough people willing to trade regularly. AMM addresses the limited liquidity issue by creating liquidity pools and rewarding liquidity providers for supplying assets to these pools. The more assets in the pool, the stronger the liquidity, making trading on decentralized exchanges easier.
On AMM platforms, users trade not between buyers and sellers but using liquidity pools. Essentially, a liquidity pool is a shared token pool. Users provide tokens to the liquidity pool, and the price of tokens in the pool is determined by a mathematical formula. By adjusting the formula, liquidity pools can be optimized for different purposes.
Any on-chain user can become a liquidity provider by providing tokens to AMM's liquidity pool. Liquidity providers typically earn fees by providing tokens to the pool. These fees are paid by traders interacting with the liquidity pool.
Algorithm Types of Automated Market Maker (AMM)
There are various types of AMM, with Constant Function Market Makers (CFMM) being the most popular category currently used to facilitate decentralized exchanges of digital assets. These AMM exchanges are based on a constant function, where the combined asset reserves of the trading pair must remain unchanged. In non-custodial AMM, user deposits for trading pairs are pooled in smart futures, allowing any trader to leverage the futures for token swaps. Thus, trades are conducted based on smart futures (pooled assets) rather than directly with counterparties (such as order trades). Since 2017, there have been three primary designs of constant function market makers on the market: Constant Product Market Maker (CPMM), Constant Sum Market Maker (CSMM), and Constant Mean Market Maker (CMMM).
Constant Product Market Maker (CPMM), popularized in Bancor and Uniswap, operates based on the function x*y=k, where the function adjusts the price range of two tokens based on the availability (liquidity) of each token. As the supply of token X increases, the supply of token Y must decrease, and vice versa, to maintain a constant product K. When plotted, this function results in a hyperbolic curve, where liquidity is always available, but prices increase towards infinity at both ends.
Advantages of Automated Market Maker (AMM)
Blockchain-driven Decentralized Trading: AMM, as a product of blockchain innovation, facilitates a decentralized trading environment without the need for intermediaries. AMM users can trade without registration, disclosing personal information, or trusting third parties to manage their funds. All users need is a self-custodied wallet to ensure higher levels of security and control over their assets.
Enhanced Liquidity Access: AMM offers traders the advantage of accessing a variety of trading pairs, some of which may not be available on traditional exchanges. Additionally, they provide liquidity pools capable of handling multiple assets simultaneously, enabling more complex and diversified trading strategies.
Reduced Transaction Fees: Operating costs for AMMs are significantly lower compared to the high fees typically charged by centralized exchanges (which rely on these fees as their primary source of income). This fee structure makes transactions more economical and efficient. For example, the popular AMM Uniswap charges only a 0.3% fee per transaction.
Algorithmic Pricing: AMM uses algorithms to set asset prices, helping to eliminate certain pricing risks common in centralized exchanges. One such risk is front-running, where traders exploit pre-knowledge about impending trades. Algorithmically determined asset prices in AMM contribute to a fairer, more stable trading environment.
Flexibility and Integration: The open-source nature of AMM allows them to be integrated into various DeFi protocols, not just for trading. This includes applications in the lending sector. This flexibility not only demonstrates the adaptability of AMM but also enriches the DeFi ecosystem by supporting a range of financial services and innovations.
Risks of Automated Market Maker (AMM)
Impermanent Loss: One of the risks associated with liquidity pools is impermanent loss, which occurs when the price ratio of pooled assets fluctuates. This happens when the price ratio of pooled assets deviates from the price at which funds were deposited. LPs automatically incur losses in such situations. The larger the price movement, the greater the loss. Impermanent loss typically affects token pools containing volatile digital assets.
However, this loss is impermanent, as price ratios can potentially recover. Losses only become permanent if LPs withdraw their funds before the price ratio returns. Additionally, it's worth noting that transaction fees and potential yield from LP token staking can sometimes offset such losses.
Slippage: Slippage essentially occurs when there is a change in quoted prices on DEXs from the time of quoting to the time of execution. AMMs typically provide tools to set slippage limits, helping traders limit their slippage and better control their trades.
The Issue Of Low Capital Efficiency: Automated Market Makers (AMMs) face the challenge of requiring a substantial amount of liquidity to match the levels seen in order book-based exchanges. A significant portion of AMM liquidity becomes available only when the pricing curve exhibits exponential changes. Consequently, due to substantial slippage, most liquidity will never be utilized by rational traders. Liquidity providers in AMMs lack control over the price points offered to traders, leading some to label AMMs as "lazy liquidity," indicating underutilization and inadequate supply. In contrast, market makers on order book-based exchanges can precisely control the price points at which they want to buy or sell tokens. This results in very high capital efficiency but requires active participation and supervision of liquidity supply.
Popular DEXs with Automated Market Makers (AMMs)
Uniswap
Launched in 2018 and built on Ethereum, Uniswap is a leading DEX known for its extensive liquidity. Its open-source nature has led to numerous adaptations and iterations. Uniswap's liquidity pools typically contain two different tokens, providing a simple and user-friendly trading experience.
SushiSwap
Emerging as a fork of Uniswap, SushiSwap retains most of the parent protocol's functionalities but introduces the SUSHI token. This token serves as an additional incentive for liquidity providers, enhancing rewards and potentially attracting more participants to its ecosystem.
PancakeSwap
While structurally similar to Uniswap, PancakeSwap's difference lies in catering to altcoins on the Binance Smart Chain (BSC). The focus on BSC tokens offers advantages such as reduced transaction fees and decreased latency, especially considering Ethereum's network congestion issues.
Balancer
Although smaller compared to similar products, Balancer offers unique features in its AMM protocol. It supports liquidity pools for up to eight different tokens, contributing to more stable pricing dynamics. Unlike other DEXs where trading fees are determined by the platform, Balancer allows liquidity pool creators to set their own fees. This feature stimulates competition among pools and provides users with the flexibility to create selective participation in private liquidity pools.
Curve
Curve adopts a mechanism of hybrid CFMM, creating a curve with constant sum characteristics within its core range and ensuring liquidity at both ends of the curve. Such a mechanism enables it to provide extremely low slippage for stablecoin trading on DEXs while ensuring liquidity.
Conclusion
Automated Market Maker (AMM) systems represent a revolutionary innovation. Despite shortcomings in trading depth and trading pricing power, their advantages in decentralization, automation, and trading convenience allow them to complete trades even under conditions of no order book. Currently, automated market makers are still in the early stages of development, but their immense potential suggests that they will achieve more breakthroughs in the future.
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