The working mechanism of AMM is very simple. It has a liquidity pool containing two coins that you want to exchange. Your job is just to deposit one cryptocurrency into the liquidity pool and withdraw another. According to the mathematical formula described in the next section, this deposit or withdrawal will affect the value of those two crypto-assets. This process is quite similar to that of fast conversion services such as ShapeShift and Changelly, but the difference here is that liquidity pools will replace the company's reserves.
So, where are these liquidity pools to be found?
A liquidity pool consists of 2 assets in a trading pair provided by users, creating a need for those two assets to be exchanged. People who contribute their crypto assets to create a liquidity pool will enjoy a certain interest rate when other users exchange the two assets they provide. The trading pair they add to the pool and the exchange will determine the interest rate.
Although Bancor was the first online AMM, the most popular tools right now are Uniswap, Curve, Kyber, and Balancer.
2. Why do these exchanges exist?
They provide liquidity quickly and at a lower cost.
Automated market makers are a solution to the limitations of smart contract blockchains, particularly Ethereum. Before AMM became popular, decentralized trading platforms built on Ethereum, like EtherDelta or 0x, always relied on traditional order book mechanisms.
However, they have liquidity problems that include placing orders that consume fuel or require block confirmation wait times. Ethereum's low throughput also limits the number of transactions received before the Blockchain reaches its peak.
This primarily affects market makers, who provide liquidity through trading order books. "Creating" a real market requires flexibility in terms of constantly changing prices. When an order requires both money and time to execute, the spread - the difference between the highest ask price and the lowest bid price - can be lost.
As the name implies, AMM reduces the cost and complexity of providing liquidity by utilizing a simple and fully automated process. Even everyday users can make the provision of liquidity much easier than traditional exchanges that may require more technical knowledge.
3. How does AMM work?
The price of cryptocurrencies will be determined through a mathematical formula.
When trading on an AMM, users interact with a liquidity pool. When a user requests a conversion from one cryptocurrency to another, a mathematical formula is automatically run to determine the value of tokens that the user may receive from time to time in terms of quantity and price.
The simplest formula is X x Y = K.
In which:
- X and Y are the number of Tokens in the pool
- K is a given constant that remains unchanged.
This equation will take the form of a hyperbola: a phenotype asymptotic to both infinity and zero at the extremes.
Each trade will have a certain slippage - the degree of mutual influence between the order size and the last price executed. This type of hyperbole has lesser slippage on small orders, but the slippage increases dramatically as the order size grows larger. Uniswap has always used this formula, but other platforms may use more complex algorithms to actively adjust for slippage.
4. How can users use the automated market maker?
Wallet link and transaction verification
Using a relatively simple AMM protocol: Users can visit the website or other relevant platforms, link a DeFi wallet to the protocol, select an asset to sell or buy, press "Convert", and confirm the transaction on the wallet.
The process of providing liquidity is similar to trading. After linking a wallet, users can go to the "liquidity providers" section and choose how much they want to deposit into the pool. They will be required to provide both types of assets in many protocols. For example, if ETH is exchanged for 4,4400 USDT, they need to simultaneously provide 1 ETH and 4,400 USDT to create a liquidity pool.
Following transaction confirmation, the user will receive a token representing their assets within the liquidity pool. After that, the token can be transferred to anyone or converted back into previous coins plus additional value.
5. Why does AMM become so popular?
Decentralization and unlimited usage are big pluses
Automated market makers solve the biggest hurdle facing the public by bringing decentralized exchanges closer to the masses: liquidity. When that is no longer a problem, the natural benefits of a decentralized exchange will come into play.
Unlike traditional centralized exchanges, there is no such thing as a "gatekeeper" to screen projects or users. AMM's protocol is an open protocol that does not require users to create their own accounts or verify user identities. A wallet address is all we need to interact with protocols.
From a project perspective, a decentralized exchange is a great way to introduce a token to the market and provide liquidity. There aren't any listing fees or admission requirements, so anyone, including those with no experience in the field, can set up a liquidity pool for all types of Tokens.
Universalizing liquidity will also enable project supporters and holders to help create a liquid market for new tokens without the help of an experienced market maker. In addition, AMM decentralized exchanges generally have a relatively simple interface, as they no longer display advanced call options or price charts on the dashboard.
6. What are the risks and limitations of AMM?
Bugs, inaccurate pricing, and temporary losses
Aside from the positives, AMM's products have some risks and limitations. Network intrusions and vulnerabilities have been issues for exchanges like Uniswap and Balancer, where liquidity providers occasionally see wild money fly away after complex smart contract interactions. On the other hand, the trader exposes his strategy to the rest of the world, allowing the faster players to execute orders first and exploit other users.
Without a traditional order book, automated market makers would not exist in terms of arbitrage control. Regardless of how useful they are, mathematical formulas cannot fully represent market sentiment. Spread traders need to fix the asset's price on one AMM, which incurs Impermanent losses on many exchanges.
In a nutshell, these traders need to profit by establishing an equilibrium price, but this profit is extracted from the liquidity providers themselves. Even if they receive a transaction fee, liquidity providers may lose money if the price fluctuates dramatically. This loss is "temporary" because the price will always reverse, but this does not always happen in practice.
Despite gradual improvement, trading volume and liquidity on AMMs remain low compared to the largest centralized exchanges. Fuel congestion in summer 2020 also shows that they are pushing fuel to its limits and require more reasonable consumption measures to prepare for future developments.
