What is an Automated Market Maker AMM?

The well-known DEX Uniswap, which is based on the Ethereum blockchain, is an example of an Automated Market Maker (AMM). To determine the exchange rate between two digital assets in the liquidity pool, Uniswap employs a constant product formula. For instance, Uniswap V2 offered traders the ability to create liquidity for any ERC-20 token pair. And V3 offers concentrated liquidity, a feature that lets liquidity providers earn similar trading fees at lower risk, since not all their capital is at stake.

What is impermanent loss?

It is described as centralised because there is a single point of control for the service – from both a technology and management perspective – with which the user has to establish trust by supplying KYC. DEX’s are a core component of DEFI – decentralised finance – generating 24hr trading volume in excess of $2bn, according to Coingecko. The AMMs we know and use today like Uniswap, Curve, and PancakeSwap are elegant in design, but quite limited in features. This should lead to lower fees, less friction, and ultimately better liquidity for every DeFi user. Learn more about Consensus 2024, CoinDesk’s longest-running and most influential event that brings together all sides of crypto, blockchain and Web3. Andrey Sergeenkov is a freelance writer whose work has appeared in many cryptocurrency publications, including CoinDesk, Coinmarketcap, Cointelegraph and Hackermoon.

Constant sum market maker (CSMM)

Even though the pool is exposed to impermanent loss, it still can be profitable thanks to reward fees.Impermanent loss only happens to people that contributed assets to the liquidity pool. Even though the need for a counterparty is eliminated, AMMs still require someone to make the market liquid. Regular users called cryptocurrency liquidity providers (LPs) provide liquidity in smart contracts.

What Then Is an Automated Market Maker?

If you sell BNB for BUSD on Binance DEX, there’s someone else on the other side of the trade buying BNB with their BUSD. An AMM works similarly to an order book exchange in that there are trading pairs – for example, ETH/DAI. However, you don’t need to have a counterparty (another trader) on the other side to make a trade. Instead, you interact with a smart contract that “makes” the market for you. In essence, the liquidity pools of Uniswap always maintain a state whereby the multiplication of the price of Asset A and the price of B always equals the same number. To mitigate the risks of facing an impermanent loss, one can consider investing in the pools with stablecoin pairs because, by nature, they are less volatile.

1. They may, however, have downsides like transient loss, slippage, and platform concerns.
2. X and y are equal amounts of a liquidity pool’s assets while k is the total or constant amount of pool liquidity.
3. In some instances, you can then deposit – or “stake” – this token into a separate lending protocol and earn extra interest.

Decentralized exchanges (DEX) known as automated market makers (AMM) enables users to trade cryptocurrencies without the use of an order book or centralized exchange. Instead, an AMM uses a liquidity pool and self executing computer programs and smart contracts to make transactions between market participants possible. If an AMM doesn’t have a sufficient liquidity pool, it can create what is process costing a large price impact when traders buy and sell assets on the DeFi AMM, leading to capital inefficiency and impermanent loss. To incentivize liquidity providers to deposit their crypto assets to the protocol, AMMs reward them with a fraction of the fees generated on the AMM, usually distributed as LP tokens. The practice of depositing assets to earn rewards is known as yield farming.

Hence, exchanges must ensure that transactions are executed instantaneously to reduce price slippages. Liquidity mining is a passive income model with which investors utilize existing crypto assets to generate more cryptocurrencies on DeFi platforms. After clicking the swap button, the algorithm calculates how much the trade impacts the liquidity pool’s reserves – after which a price quote is given. Liquidity pools allow users to make transactions directly on the blockchain and seamlessly switch between tokens in a completely decentralized and non-custodial manner. Simply put, market making is the activity of providing liquidity to a market by simultaneously quoting prices to both buy and sell an asset.

An example of such a model is Curve Finance, which combines CPMM and CSMM models to offer a capital-efficient platform to exchange pegged assets. Trading (or swapping) cryptocurrencies is one of the most common transaction types that contributes to the overall activity in the decentralized finance (DeFi) ecosystem. Now that you understand what market making is, it is easier to grasp the workings of an automated market maker. Both banks and centralized exchanges record their buy and sell data in a central log (order book) and then offers on that log are matched with each other according to best fit. You’re likely to read about AMMs a lot if you’re learning the ins and outs of DeFi; but what on earth is an automated market maker anyway?

If you are concerned about moving the market and price slippage on a DEX you can consider breaking your trades into smaller chunks, waiting for the liquidity pools to rebalance. This, however, needs to be balanced against paying higher fees for more transactions. An automated market maker, otherwise https://cryptolisting.org/ known as an AMM, is a means of offering cryptocurrency trading without the need for an intermediary. AMMs combine Smart Contracts and incentives for liquidity provision to automate cryptocurrency trading and disrupt the traditional centralised exchange model, replacing it with the DEX.

This makes synthetic assets more secure because the underlying assets stay untouched while trading activity continues. They also help in risk management since adjusting parameters dynamically based on external market conditions can help mitigate the risk of impermanent loss and slippage. Synthetic assets are a way for AMMs to use smart contracts to virtualize the AMM itself, making it more composable. An implementation of this can be seen in virtual AMMs (vAMMs), where market participants trade using synthetic tokens (vDAI for DAI, vETH for ETH, etc.) while their actual crypto is locked in a smart contract.

To get started in DeFi, simply buy cryptocurrency via MoonPay using your credit card or any other preferred payment method. This allows AMMs to actively adjust the price in their market to be more in line with the external market price. Uniswap is a market maker giant with over $3 billion total value locked (TVL), dominating over 59% of overall DEX volume. The competitive advantage of Uniswap lies in its peerless high liquidity, financial incentives in UNI rewards, and technological evolution.

Examples of decentralized exchanges that distribute governance tokens to incentivize LPs are Uniswap (UNI), SushiSwap (Sushi), Compound (COMP), and Curve (CRV). Aside from earning a portion of the protocol’s fees, the governance tokens represent an additional income source for liquidity providers. The tokens are called governance tokens because they often confer certain rights, such as voting rights on protocol changes or rights to a portion of the protocol’s profits.

AMMs offer advantages that help introduce many DeFi features that traditional exchanges cannot replicate. Both track the best paths for gathering liquidity at the best price possible. You can try out smart order routing by registering an account on Shrimpy and swapping tokens. After approving the transaction, the AMM deposits UNI tokens into the ETH-UNI pool. Finally, it sends the quoted amount of ETH from the pool to the customer’s wallet. An easy way to understand AMM-based exchanges is to consider how they differ from traditional exchanges.

If the ratio changes by a wide margin, there’s going to be a large amount of slippage. So there’s no need for counterparties, but someone still has to create the market, right? The liquidity in the smart contract still has to be provided by users called liquidity providers (LPs). With each trade, the price of the pooled ETH will gradually recover until it matches the standard market rate. When comparing order book vs AMM, traditional stock exchanges and centralized cryptocurrency exchanges use the order book model to express the Demand and Supply and let them form an asset’s price. The main goal of the buyer (bidder) is to buy an asset for the lowest price possible, while sellers (askers) try to sell an asset as high as possible.

AMMs work by replacing the traditional order book model with mathematical formulas and logic wrapped in smart contracts. Conversely, centralized exchanges (CEXs) use an order book to match a buyer with a seller to execute a cryptocurrency trade at a mutually agreed exchange price. To unpack that a bit, order books make use of a trading system that’s peer-to-peer, whereas AMMs are peer (liquidity provider) to contract (the liquidity pool) to peer (the user who just actioned the exchange). First, the liquidity of the system is determined by how many people want to trade at a given moment – and what asset they are trading. So, say I wanted to use my ETH to purchase one of the rarer tokens – for an order book system to be of use to me, there would need to be someone looking to sell that rare crypto for ETH. And even then, we’d still need to agree on price before the trade could take place.

In this regard, liquidity is an indicator or a measure of the “availability” or the speed at which an asset can be bought or sold without noticeably affecting its price stability. Crypto Futures and CFDs products are complex financial instruments which come with a high risk of losing money rapidly due to leverage. You should consider whether you understand how leveraged products work and whether you can afford to take the inherently high risk of losing your money. Each platform has its own special features and advantages, like Uniswap’s simplicity of use, SushiSwap’s selection of DeFi services, and Balancer’s adaptability in pool design.