The rise of decentralized finance (DeFi) changed the way people perceived cryptocurrencies and everything that is related to blockchain. One of the essential ways in which the DeFi protocol operates is by using an automated market maker (AMM). Although many investors may not be familiar with AMMs, especially newbies in the world of crypto, they play an integral role in ensuring liquidity on a decentralized exchange.
Let’s go ahead and discuss exactly what an AMM is, how it works, and why it’s an integral component of DeFi.
Defining an Automated Market Maker (AMM)
An automated market maker (AMM) allows digital assets to be traded without permission and automatically by using liquidity pools instead of a traditional market of buyers and sellers. On a traditional exchange platform, buyers and sellers offer up different prices for an asset. When other users find a listed price to be acceptable, they execute a trade and that price becomes the asset’s market price. Stocks, gold, real estate, and most other assets rely on this traditional market structure for trading. However, AMMs have a different approach to trading assets.
AMMs are a financial tool unique to Ethereum and decentralized finance (DeFi). This new technology is decentralized, always available for trading, and does not rely on the traditional interaction between buyers and sellers. This new method of exchanging assets embodies the ideals of Ethereum, crypto, and blockchain technology in general: no one entity controls the system, and anyone can build new solutions and participate.
How does an automated market maker (AMM) work?
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.
On a decentralized exchange like Binance DEX, trades happen directly between user wallets. 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. We can call this a peer-to-peer (P2P) transaction.
In contrast, you could think of AMMs as peer-to-contract (P2C). There’s no need for counterparties in the traditional sense, as trades happen between users and contracts. Since there’s no order book, there are also no order types on an AMM. What price you get for an asset you want to buy or sell is determined by a formula instead. Although it’s worth noting that some future AMM designs may counteract this limitation.
So there’s no need for counterparties, but someone still has to create the market, right? Correct. The liquidity in the smart contract still has to be provided by users called liquidity providers (LPs).
The role of Liquidity Providers in AMMs
As mentioned, AMMs require liquidity to function properly. Pools that are not adequately funded are susceptible to slippages. To mitigate slippages, AMMs encourage users to deposit digital assets in liquidity pools so that other users can trade against these funds. As an incentive, the protocol rewards liquidity providers (LPs) with a fraction of the fees paid on transactions executed on the pool. In other words, if your deposit represents 1% of the liquidity locked in a pool, you will receive an LP token which represents 1% of the accrued transaction fees of that pool. When a liquidity provider wishes to exit from a pool, they redeem their LP token and receive their share of transaction fees.
In addition, AMMs issue governance tokens to LPs as well as traders. As its name implies, a governance token allows the holder to have voting rights on issues relating to the governance and development of the AMM protocol.
What you need to know about impermanent loss
While being a liquidity provider sounds like an easy way to earn transaction fees, there are dangers involved with depositing your crypto. One of these risks is called impermanent loss. This occurs when the price of your deposited crypto in a liquidity pool fluctuates from the price when you first deposited it.
The bigger the shift in price, up or down, the more you would lose or gain if you withdraw your deposit. It’s not technically a loss until you do actual withdrawals, which is why they’re referred to as impermanent losses.
However, this is a significant risk for smaller altcoins and cryptocurrencies, where big price swings might never end up reversing. Becoming a liquidity provider for an entirely new altcoin, where prices are incredibly volatile, could be very dangerous for providers.
Final Thoughts
While automated market makers can be hugely useful within DEXs, they certainly pose certain risks for traders and investors. This is why it’s always important to understand whatever DeFi service you want to use before putting any of your funds forward. That way, you can prepare as much as possible for unexpected price dips or crashes.
AMMs are still in their infancy. The AMMs we know and use today like Uniswap, Curve, and PancakeSwap are elegant in design, but quite limited in features. There are likely many more innovative AMM designs coming in the future. This should lead to lower fees, less friction, and ultimately better liquidity for every DeFi user.
