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What Is An Automated Market Maker (AMM) And How Does It Work?

People who pay close attention to decentralized finance will come across the term AMM or Automated Market Maker. It is a very intriguing concept that facilitates trading without human intervention. Traders will always receive a price at which they can buy or sell particular assets. Depending on their order volume, it may impact the overall average price for better or worse.

The main benefit of using an AMM is its trustless environment. Price information is often sourced from multiple APIs to provide the most accurate value at all times. Furthermore, anyone can become a liquidity provider for Automated Market Makers and earn trading fees for doing so.

Volume-wise, AMMs are the most popular DeFi concept on the market today. They represent billions in liquidity and trading volume. However, a decentralized way of trading cryptocurrency that empowers all users is what this industry needs more of.

The Advent Of Decentralized Finance

With the help of blockchain technology, developers can decentralize any known aspect of finance. Moreover, thanks to smart contracts, most of those processes can be automated by their creators. Known as decentralized finance, there are many opportunities regarding lending, borrowing, yield farming, liquidity provision, and so forth. All of these products and services are accessible to anyone without intervention from banks and governments.

Several automated market maker protocols keep gaining traction in decentralized finance today. Notable examples include Uniswap, SushiSwap, 1INCH, PancakeSwap, and many others. These platforms succeed in noting competitive trading volume, more than sufficient liquidity, and cater to a growing number of users. The big question is whether they will ever overtake traditional centralized exchanges. A tall order, but nothing is impossible in this industry.

An AMM Is Not A Traditional Exchange

On the surface, one may think that a traditional exchange and an automated market maker are the same. That is because they both facilitate trading across different markets at acceptable fees. However, there are several crucial differences to take into account.

First, an AMM has no order book. Instead, its liquidity pool is used for buying and selling in real-time at the best possible price. Assets are priced through mathematical formulae and by leveraging data from decentralized price oracles. Thanks to native pricing algorithms, trades are executed immediately and at the current price.

Different AMM protocols maintain different pricing algorithms and formulae to price assets. It is not something to worry about as a user, yet it is crucial to note slight differences under the hood. Those who have a technical itch they want to scratch can always explore the inner workings of such formulae and why they are set up in such a manner.

On the other hand, traditional exchanges rely on market makers and market takers to keep the price spread as small as possible. Large discrepancies in the order book can trigger volatile price swings, potentially spooking the entire market. Decentralizing the trading and matching process empowers the users and allows for the creation of new markets. 

The Inner Workings Of An Automated Market Maker (AMM)

One can argue that an automated market maker is not that different from an exchange regarding trading pairs. However, most AMMs have many more markets, allowing for other trading options. The big difference is how AMMs do not require counterparties to complete orders or traders, as everything is based on the liquidity in the trading pair’s pool. All interactions occur via a smart contract rather than human traders.

Some decentralized exchanges go one step further and let users trade directly between their wallets. Such peer-to-peer transactions remain a big selling point of the cryptocurrency industry today. AMMs, on the other hand, are peer-to-contract, as they remove the need for a second trader to be active at the time of the order being submitted.

One potential downside to using an automated market maker is how there are no “order types”, such as stop-loss orders. Instead, users pay the price they see on the screen and receive the value determined by a formula. That is a severe limitation to some users, whereas others think it is the next logical step in the evolution. Future generations of AMMs may opt for a different approach. However, for now, the peer-to-contract process remains prevalent.

An AMM would not be able to exist without liquidity. Similar to traditional exchanges, funds are required to perform trades. Anyone with the right asset in their portfolio can provide liquidity to an AMM. That process is known as liquidity provision, usually through liquidity pools.

Understanding AMM Liquidity Pools

As decentralized exchanges and automated market makers forego the idea of order books, creating a market requires a different approach. Instead of using a maker and taker order book, AMMs rely on liquidity pools. A liquidity pool is, in essence, a heap of funds consisting of two assets that make up a trading pair. For example, ETH-USDT is such a pair where users can share their ETH and USDT liquidity to earn trading fees. In most cases, users need to deposit an equal value for every asset to ensure pool stability.

The main draw of an automated market maker is how anyone can be a market maker. Adding funds to a liquidity pool is straightforward and takes mere seconds. Depending on the platform one uses, the trading fees for liquidity providers are above, below, or equal to 0.3%. Popular pairs will generate more fees and have more liquidity providers fighting for their share of the proverbial pie.

One interesting aspect of AMMs to keep in mind is “slippage”. The slippage ratio depicts how much of an impact every order will have on the pool’s liquidity and the ratio between the two tokens in that market. If there is a significant change, the slippage will grow above 10% with relative ease. Usually, it is 1% or less if there is sufficient liquidity in the pool. The slippage rate can also make traders pay more or receive fewer of one pair’s tokens if their order is too large. 

You Can’t Ignore Impermanent Loss

While all of the above sounds very exciting, no opportunity in cryptocurrency is without risks. Liquidity providers face one big threat in the form of impermanent loss. That phenomenon will occur when the price ratio of pooled tokens changes after a user deposits them. Prices of these assets can go up or down, except for stablecoins. The more significant this price change, the bigger the impermanent loss. 

The concept of impermanent loss creates a tough balancing act for liquidity providers. While earning trading fees may seem ideal, one never knows how prices of assets will evolve. It is much better not to provide liquidity and hold the tokens in a wallet in most cases. There are exceptions for popular trading pairs, assuming they can generate sufficient fees for users to overcome the impermanent loss deficit. 

There is no way to avoid impermanent loss, unless one wants to keep funds in a liquidity pool until the price returns to the prior level. Providing liquidity for a longer period will still generate fees for the user. As such, there are ways to be profitable as a liquidity provider, although it may require some napkin math first and foremost. Comparing the different options and seeing which option may offer the best results is crucial in this ever-changing industry.

Closing Thoughts

One cannot deny the overall appeal of automated market makers or AMMs. Giving anyone an option to provide liquidity and earn trading fees is very appealing. Even though there is the risk of impermanent loss, most users do not seem to give this a second thought. When one can contribute good liquidity to a top-rated pool – or one with two stablecoins – there is often a clear path to earning a profit ahead.

At the same time, one has to keep in mind that AMMs are in the early stage of development. Despite the popularity of Uniswap, pancakeSwpa, and others, their feature set remains incredibly limited. One can argue such platforms don’t need unnecessary bells and whistles, yet it is crucial to keep innovating. Moreover, developers can reduce the fees further, and friction needs to be addressed. There’s also how these platforms may not appeal to people who aren’t versed in cryptocurrencies.

It will be interesting to see what the future holds for automated market makers (AMMs). Many people hope to see these platforms displace traditional exchanges sooner or later. So far, that is not happening yet, despite most of these platforms noting a decent trading volume. 

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