The rise of decentralized finance (DeFi) has changed the way we buy and sell cryptocurrencies. This article shows a detailed explanation of Automated Market Makers for DeFi, how it works, benefits, and more!
Automated Market Maker explained
The rise of decentralized finance (DeFi) has altered how we purchase and sell cryptocurrencies. Price and other information about goods and services require active participation from buyers and sellers in traditional trading.
Most of the time, an intermediary handles the entire process, ensuring that the transaction is carried out securely. One of the most important aspects of any DeFi protocol is the use of an automated market maker.
Despite the fact that many investors are unfamiliar with AMMs, they play an important role in ensuring liquidity on a decentralized exchange. An Automated Market Maker (AMM) facilitates the trading of digital assets in a permissionless and automatic manner by utilizing liquidity pools rather than a traditional market of buyers and sellers.
What is Automated Market Maker?
A system that automatically facilitates buy and sell orders on a decentralized exchange is known as an Automated Market Maker (AMM). AMMs, unlike traditional market makers, operate through the use of self-executing computer programs known as smart contracts. These smart contracts match transactions between buyers and sellers automatically.
AMMs also eliminates the need for a second participant when making a trade. Buyers and sellers can instead trade directly with the AMM and its algorithm, which determines the price of a cryptocurrency.
AMMs are not used by centralized crypto exchanges such as Blockchain.com or Currency.com. However, while AMMs automate the transaction process, liquidity providers are still required for AMMs to function.
To function, automated market makers rely on liquidity pools and liquidity providers. A cryptocurrency liquidity pool is a cryptocurrency reserve that is used to facilitate future trades. Those who contribute funds to these pools are known as liquidity providers.
You can check out this great article on Liquidity Pools in DeFi
Automated Market Makers for DeFi: How do Automated Market Makers work
A trading pair is a concept used in exchanges. Pairs exist to properly quote the value of two currencies to see how they compare. Users contribute token “Pairs” to liquidity pools, and the price of the tokens in the pool is determined by a mathematical formula.
By supplying tokens to an AMM’s liquidity pool, anyone with ERC-20 tokens can become a liquidity provider. For providing tokens to the pool, liquidity providers typically earn a fee. Traders who interact with the liquidity pool must pay this fee. Liquidity providers can now earn yield in the form of project tokens through a process known as “Yield Farming.”
You can check out this great article on How Yield Farming Works
With AMM algorithms, instead of trading between buyers and sellers, users trade against a pool of tokens using a mathematical formula. The formula can vary with each protocol, but the most common one used by already established protocols like Uniswap is x*y=k.
Where x is the quantity of one of the pair tokens in the liquidity pool and y is the quantity of the other pair token, k indicates that the price of tokens in a liquidity pool is determined by a constant balance of assets.
To avoid an imbalance, the formula above states that if you want to withdraw a certain amount of token x, you must also deposit an equal amount of token y. For example, if an AMM contains Ethereum (ETH) and Bitcoin (BTC), two volatile assets, the price of BTC rises every time BTC is purchased because there is less BTC in the pool than before the purchase.
In contrast, as there is more ETH in the pool, the price of ETH falls. The pool is always in balance, with the total value of BTC in the pool equaling the total value of ETH in the pool.
Automated Market Makers list
The Automated Market Maker (AMM) market cap today according to CoinGecko is $7.55 Billion, a 4.4% change in the last 24 hours. Some of the best Automated Market Maker platforms include:
Striving for an open and accessible marketplace for all, Uniswap utilizes an AMM mechanism to calculate the price of tokens based upon the ratio of the tokens in the liquidity pools. Any user can provide liquidity. Uniswap price as of this writing is $6.21 with a 24-hour trading volume of $177,190,863.
PancakeSwap is a Decentralized Exchange (DEX) built on top of Binance Smart Chain (BSC). It is the biggest Automated Market Maker (AMM) based exchange in BSC that uses AMM algorithms to facilitate trades. As of this writing PancakeSwap price is $4.02 with a 24-hour trading volume of $32,483,430.
Osmosis is a fully-customizable AMM that allows developers to build truly unique liquidity pools, and build and deploy custom AMMs that can quickly adjust to changing market conditions. Osmosis price today is $0.999330 with a 24-hour trading volume of $5,248,471.
Curve is a decentralized exchange for stablecoins that controls liquidity with an automated market maker (AMM). As of this writing Curve DAO price is $0.656505 with a 24-hour trading volume of $40,634,218.
1inch is a next-generation automated market maker (AMM) that safeguards users from front-running attacks, provides capital efficiency to liquidity providers and makes sure traders can buy and sell ERC-20 tokens without being overly impacted by slippage. As of this writing 1inch price is $0.500380 with a 24-hour trading volume of $31,635,902.
SushiSwap is a DeFi protocol that is completely community-driven, serving up delicious interest for your held crypto assets. However, due to the decentralized nature of being an AMM, SushiSwap has fewer hurdles to execute your cryptocurrency trades, and all fees are paid to the users who provided liquidity. As of this writing, SushiSwap price is $1.37 with a 24-hour trading volume of $69,254,092.
You can check out this great article on SushiSwap review
Automated Market Maker Vs Order Book
In short, Automated Market Maker (AMM) is a new wave of decentralized finance integrated into decentralized exchanges to help facilitate trades, while the Order Book is a traditional method of carrying out trades between two parties. Order books are found in centralized exchanges.
Automated Market Maker
Automated market makers enable permissionless, non-custodial, and automated cryptocurrency trading.
In contrast to order book exchanges, where users place orders and wait for them to be filled, AMMs process all transactions automatically, without relying on third-party buy/sell requests.
AMMs, on the other hand, use liquidity pools in conjunction with an algorithm that determines token prices based on the changing ratio of tokens supplied.
Order books are found on CEXs and keep track of all ongoing trading activity, providing arguably more advanced functionality than AMMs.
They show separate sections for buyers and sellers, with the sellers’ section displaying asks and the buyers’ section displaying bids, and the current market price of the asset being traded is always displayed.
They also enable users to place limit orders, which allow you to specify the price at which you want to buy or sell an asset. When the asset reaches the price you specify, the order book will automatically execute the trade for you.
To know more about Order Books, you can check out this great article on Crypto Order Book.
Benefits of Automated Market Makers
Anyone can become a Liquidity Provider
Anyone can become a Liquidity Provider especially if you’re a whale. Instead of having all those tokens sit in your wallet doing nothing you can actually put them to work by donating some of them to liquidity pools and earning a fortune while doing so.
Providing liquidity entails you have done due diligence to research what it entails to be a liquidity provider and the risks involved like impermanent loss.
Below are some educational resources to help you provide liquidity in liquidity pools for different protocols:
Providing liquidity in Uniswap
Providing liquidity in SushiSwap
Providing liquidity in PancakeSwap
Peer to Smart Contract Interaction
Trades in AMM-based DEXs are peer to Smart contracts. You trade with a smart contract rather than a peer-to-peer network. Each asset’s price is determined algorithmically.
All exchanges are coded by programmers in what is known as a “Smart Contract.” You do not need to interact with anyone before exchanging tokens. As a result, it has resolved the issues of transfer delay and manually-induced slippage.
Furthermore, the Smart Contracts of some decentralized exchanges (DEXs) are so robust that if a token isn’t available on its platform, it can search for the unavailable cryptocurrency on other platforms.
Slippage is the sharp difference in asset prices at entry and exit points. AMM did not solve all of the slippage issues. It did, however, reduce the rate at which there is a significant price difference between when you buy and sell or vice versa.
In a volatile environment like the crypto space, asset prices can drop or rise dramatically in a matter of minutes. The use of manual order books resulted in significant slippage. AMM reduced transaction processing time, lowering the possibility of slippage.
Automated Market Makers for DeFi: Conclusion
Automated market makers are one of the biggest innovations in the DeFi industry. They allow virtually anyone to create markets in a seamless and efficient manner. While they have limitations when compared to order book exchanges, the overall innovation they bring to cryptocurrency is priceless.