What are Automated Market Makers (AMMs)

2021/06/17 09:02:06

Decentralized Finance (DeFi) allows the common man to access various financial services and earn money over the internet. Just like bankers in traditional finance, any stranger can now earn interest on funds they put to work. While DeFi’s provision of financial freedom is what led to its rising popularity, it is Ethereum’s smart contract platform that has facilitated its rapid growth. Applications such as Compound for yield farming, Aave for lending and borrowing or even MakerDao as a stablecoin have all been created as Ethereum decentralized applications (dApps).

However, it was DeFi’s golden child Uniswap that pioneered the Automated Market Maker (AMM) model. Uniswap has led the AMM movement to numbers such as $10 Billion in weekly trading volume in April 2021. This permissionless and non-custodial system makes it very easy for market participants to buy, sell, or trade cryptocurrencies in a fully decentralized way.

Pre-Automation Days

Traditional exchanges of today work by utilizing a market mechanism called order books. This is where buyers and sellers come together and place their requests on the exchange. The exchange acts as a matchmaking service and looks to bring together and execute the requests of both parties. In the order book system, the final price is calculated when both the buyer and the seller agree on a price.

A buyer/bidder will underbid their request and try to get the lowest price possible whereas the seller will ask more than the average rate and hope for the highest. For the trade to happen, both parties will have to meet somewhere in the middle. Standard crypto exchanges such as KuCoin, along with traditional stock exchanges like NASDAQ work with the order book model. However, now comes the issue, what if the buyer and seller are not able to agree on a midpoint or if there just aren’t enough coins for the bidder to buy?

This is where the role of market makers comes into play. Market makers define asset prices by providing liquidity to the market, rather than taking away from its liquidity. Buyers and sellers can easily trade without waiting for a counterparty on the other side. When there are not enough counterparties to trade with, the market can become illiquid and highly volatile.

For this reason, certain crypto exchanges seek the help of professional traders such as banks, brokers, or investors to continuously provide liquidity to the system. These liquidity providers (LPs) ensure there are always counterparties for users to trade against by matching their orders with bid-ask orders.

What is an Automated Market Maker (AMM)?

Rather than the traditional order book system, AMMs provide liquidity via liquidity pools through their smart contracts. In simple words, an AMM quotes a predetermined price, take it or leave it. Platforms such as Uniswap, Balancer, and SushiSwap are common users of this system. The prices for these digital assets are calculated through a pricing algorithm, the formula which varies based on the platform.

Every algorithm facilitates the trade of digital assets against the liquidity held in the liquidity pools and allows for tokens to be swapped at any time. This decentralized protocol is online 24/7, has no single entity controlling the system, and lets anyone participate and provide liquidity to other users.

How do Automated Market Makers Work?

AMMs could be thought of as P2C (peer-to-contract) systems. While trades happen between the users and smart contracts there’s really no need for counterparties. The price received is predetermined by the algorithm. An AMM works with trading pairs, such as the ETH/DAI pair.

A trader comes to a platform and wants to trade 1 ETH for DAI. The protocol’s AMM will immediately evaluate the balance between the 2 tokens in the liquidity pool and accordingly state a price for the trader. In this case, the trader is quoted a price of 2700 DAI, and can choose whether to accept it or not. In the situation that the price is accepted, the trader would receive their 2700 DAI minus the fees.

What are Liquidity Pools?

A liquidity pool, in its basic form, is a shared pot of tokens. These tokens are locked in a smart contract and facilitate AMM trading on decentralized exchanges. A single liquidity pool holds 2 tokens. The liquidity provider must add a certain proportion of the trading pair tokens to create a market for that particular pair. Since it is very easy to add funds to a liquidity pool, anyone can become a liquidity provider, making the market easily accessible.

Liquidity providers earn trading fees from the trades that happen in their pool in exchange for providing funds. When a trade occurs, the fee is proportionally distributed depending on each individual’s share of the total liquidity. Uniswap, which widely popularized the concept of liquidity pools, charges its traders with a fee of 0.3%, which directly goes to the LPs.

With liquidity pools, the more liquidity a user has, the better. As with every other market, higher liquidity means less slippage, which leads to more volume on the platform. The price of tokens on a platform is dependent upon the changes in the ratio between the 2 tokens after the trade occurs. Thus, the wider the change in ratio, the greater the slippage amount.

Case Study: Uniswap

Uniswap is the clear leader in automated market maker technology. Their algorithm uses a very simple formula to calculate the prices of the tokens, X*Y=K. In this case, X signifies the value of asset 1, Y denotes the value of asset 2, and K is a constant. Thus, no matter how much the value of asset 1 or 2 fluctuates, their product will always remain the same.

While Uniswap’s token prices are set by the pool balance, liquidity providers have to deposit at a ratio of exactly 50% between the 2 assets. Anyone and everyone can participate in Uniswap pools as this is the only requirement. Further, there are no minimum capital requirements for deposits in Uniswap. New token listings are free since it can be done by interacting directly with the smart contracts and requires no approval from the Uniswap team.

However, while Uniswap charges a flat 0.3% fee for trades from each pool, the number increases to 0.6% when non-direct pairs are involved. Non-direct pairs are pairs that get liquidity from different pools. Additionally, Uniswap’s less popular pools are only recommended for experienced users as its no-approval listing system opens the door for scammers looking to target the less aware users.

Conclusion

Automated market makers are quickly becoming a staple of the DeFi sector. Their application democratizes the process of trading by allowing the average individual to create markets efficiently and seamlessly. While it benefits liquidity providers to earn fees from each trade, it also benefits traders by providing them access to quick trades with less slippage.

While protocols such as Uniswap, Balancer, and SushiSwap have done well to follow up with the DeFi craze, they still lack in terms of features they provide. This growing industry will see constant advancements where every DeFi user will benefit from better liquidity, lower fees, and even more elegant solutions to current problems.