Automated Market Maker (AMM)

What is an Automated Market Maker?

Introduced by Vitalik Buterin in 2017, and a year later launched by Uniswap, AMM or Automated Market Maker, is a unique decentralized exchange (DEX) protocol. With the help of AMMs, users can buy and sell digital assets without any need for third-party involvement. It ensures the automated process of pricing and matching orders on the exchange, using an algorithm that identifies the prices at which buyers and sellers can trade their digital assets.

In short, it refers to a method that involves selling and purchasing crypto assets in an easygoing peer-to-peer mode without having a need for a third party to complete the transactions.

One of the key reasons why Automated Market Makers are popular is because they are easy and convenient to use and are less costly compared to traditional centralized exchange algorithms. Furthermore, AMMs are faster in operation than centralized systems. They are smoothly operated with the help of smart contracts and are secured further by the blockchain network.

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How Does an Automated Market Maker Work?

Eliminating the need for traditional order books, Automated Market Makers work based on pre-programmed algorithms and smart contracts, to execute transactions and help traders buy/sell specific cryptocurrencies based on the liquidity of the liquidity pool.

Unlike centralized exchanges, in AMM protocols, anyone can provide liquidity in the liquidity pool, once they meet the pre-determined status set up in smart contracts. The liquidity providers can earn handsome amounts of passive income for their contribution to the liquidity pool, and can trade in an automated environment without any third-party interference. The dealings are made through smart contracts at a fair market price.

Liquidity Pools

Liquidity pool refers to huge piles of funds against which trades are made. These pools are made through funding provided by liquidity providers (LPs). In return for staking their funds, LPs get a commission. Whatever trade has happened in a certain pool, LPs get their fixed percent as a reward for their investments. If you take the example of Uniswap, LPs are bound to deposit an equivalent value of two tokens, i.e., the investment share is divided as 50% of ETH and 50% of USDT for the ETH/USDT pool.

Now, the question might be popping up in your mind: can anyone become a financer or liquidity provider? Yes, it is as simple as that. The rewards or commissions are determined with the help of set protocols. A prime example is Uniswap V2, which charges 0.3% on traders’ transactions, which goes directly into the pockets of liquidity providers.

However, it is worth noting that at other DEXs, the charges, as well as commissions, might differ to attract more liquidity providers to their pool.

Automated Pricing Mechanism

Automated Market Makers use automated pricing mechanisms with the help of a pre-programmed algorithm. It adjusts the pricing of cryptocurrencies and bridges the assets available in the liquidity pool to let users know about slippage and fluctuation before they initiate a trade.

The most common equation Uniswap and other platforms use to determine a specific currency’s value is: x*y=k.

In this equation, ‘x’ represents the value of asset A, while ‘y’ displays the value of asset B.

Let’s understand this with an example. Assume that there is a liquidity pool available for ETH/USDT pair on “X” DEX. If a user needs ETH in exchange for the USDT he holds, he/she will just have to select the pair and then swap USDT with ETH. In this scenario, the user is actually removing ETH from the pool and adding USDT to it.  It results in inflation in ETH price in the pool as the supply of ETH is decreasing and vice versa.

Since 2021, Coin-Labs.com has partnered with Bybit and is few of the highest-ranking of affiliate program contracts.
Therefore, if you sign up for Bybit through the button above, you will get the most discounted fee benefit and participation in a bonus event offering up to $500.

Benefits of Automated Market Makers

A few years back, exchanging digital assets wasn’t as easy as it is today because of the unavailability of exchanges and strict regulations imposed by governments around the world. But thanks to AMMs’ model-based decentralized exchanges, these obstacles can easily be bypassed. Here are some of the benefits offered by Automated Market Makers.

Increased Liquidity

Before the Automated Market Maker era, the DEX markets were monopolized by only a few major players who made it difficult, if not impossible, for small traders to enter the market. The liquidity level was low, and the trading environment wasn’t supportive, as these “whales” were easily able to cause fluctuation in the market.

Since the rise of AMMs, more people are entering crypto trading because it offers limitless trading opportunities, due to its no minimum and maximum trading requirements. Users on AMM-supported DEX can purchase cryptocurrencies for as low as $10.

Lowering Trading Costs

As previously mentioned, it eliminates the need for middlemen, brokers, or banks to verify transactions. Unlike traditional markets that include stocks — where trades are facilitated by order books and market makers — AMMS are purely algorithmic. They automatically balance buy and sell orders by adjusting prices based on supply and demand ratios. This Automated Market Makers model not only lowers trading costs, but also ensures the availability of markets 24/7 to facilitate trading at any time.

Accessibility and Decentralization

Before the introduction of decentralized exchanges, trading was made possible through centralized exchanges or brokers. These exchanges often require users to disclose their identity by sharing personal information. Because of this, privacy and data security became two of the main concerns for participants in the crypto market.

In contrast to these conventional financial models, decentralized exchanges and AMMs offer users complete anonymity while trading, since they don’t require users to share personal information.

Automated Market Makers vs Order Book

The key difference between an AMM and Order Book model is that Automated Market Makers has a liquidity pool that automatically adjusts the pricing of the assets with respect to the available liquidity in the pool. In contrast to the Order Book model, where the buyer and seller set their prices, AMMs don’t require any manual price-setting mechanisms. All the price adjustments are done through an automated value adjustment model.

Popular Automated Market Maker Protocols

There are plenty of Automated Market Marker (AMM) protocols available in the market for traders to choose from. In this part of the article, we will discuss a few of the popular ones, as of 2023.

UniSwap

Initially launched in 2018, Uniswap was the first AMM-based decentralized exchange, and to date, is the most successful one in DeFI ecosystems across all blockchain networks. Not only does it support the Automated Market Makers algorithm, but it also has the deepest liquidity on Ethereum Blockchain.

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PancakeSwap

Launched two years after Uniswap, in 2020, PancakeSwap is also a popular decentralized exchange and Automated Market Maker protocol, built on top of Binance Smart Chain. PancakeSwap is often compared to Uniswap, and many traders even call it the Uniswap of BNB Chain (Binance Smart Chain). One of the key advantages this AMM protocol-based exchange has to offer is its low transaction fee, and fast validation rate, which helped it quickly gain popularity among crypto communities.

SushiSwap

SushiSwap is another decentralized exchange (DEX) built on Ethereum blockchain. It was launched as a branch of UniSwap in 2020. The concept of “yield farming” — also known as “liquidity mining” — was introduced by SushiSwap to boost the liquidity factor in the exchange.

Risks & Limitations of Automated Market Makers

Apart from the many benefits that Automated Market Makers bring to the table, there are also some shortcomings. AMMs are prone to price slippage and impermanent loss, which is a major risk for the traders.

The trading is limited to Altcoins only. Most AMMs based decentralized exchanges don’t support trading of BTC.

To learn about the best Altcoins to buy in 2023 click here

As Automated Market Maker protocols are automated and initiate transactions based on pre-programmed algorithms, they are in danger of exploitation by malicious forces. AMMs are new and complex and any bugs and flaws can lead to major funds loss.

Impermanent Loss

Automated Market Maker protocols provide handsome returns to the liquidity providers, but there are still some risks involved. One of the common risks involved is impermanent loss.

An impermanent loss can be defined as a net difference in the value of two cryptocurrencies in the liquidity pool, since they were staked. The more significant change in the price ratio, the bigger the loss will be. However, this loss can be minimized to some extent if you do not withdraw the invested tokens when the pool faces the shift in price ratio.

Security Risks

Although, Automated Market Maker protocols are highly secure, they are still prone to security risks. Coding bugs and logic flaws can be a major threat and lead to financial losses. There is also a risk of flash loan exploitation. As AMM protocols work on automated pre-programmed models, it allows users to borrow huge amounts from the pool without any collateral. Malicious actors can take advantage of flash loan and manipulate the liquidity pools.

The Future of Automated Market Makers

The future of Automated Market Makers (AMMs) seems bright. As DeFi continues to grow rapidly, AMMs will be adopted on a mass level. Right now only a handful of DeFi platforms support AMM protocols. But with more projects launching day by day in the DeFi ecosystem, the demand for AMMs will significantly increase, which will result in lower transaction fees and less volatility in the market.

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