An automated market maker (AMM) is the underlying protocol that powers a decentralized exchange (DEX) by enabling assets to be traded by using crypto liquidity pools as counterparties, instead of a traditional market of buyers and sellers. The protocols use algorithms instead of order books to match buyers and sellers with liquidity.
Digital assets that are swapped on AMMs in a permissionless manner reduce the need for intermediaries. The decentralized exchange protocols use smart contracts, liquidity pools, liquidity providers and in many cases data oracles to facilitate transactions.
Although AMMs existed long before crypto grew in popularity, these protocols are now mostly associated with crypto because they are essential in the decentralized finance ecosystem. They create liquidity yield opportunities without high net worth requirements.
Learn all about AMMs and the role they can play in your cryptocurrency investments.
How Do Automated Market Makers Work?
Automated market makers use formulas to power trading token pairs. For example, BTC-USDC is a trading token pair. These formulas are known as smart contracts, which create a a liquid trading market for buyers and sellers. All trading takes place on a peer-to-contract basis, which removes the need for other traders and market makers to serve as counterparties.
AMMs are free of order books and order types. Instead, formulas determine asset prices.
You do not need another party or trader to make a trade. Instead, you interact directly with that contract, which makes the market for you, hence the name automated market makers.
But with no counterparties, who is creating the market in AMM crypto protocols? Liquidity providers start the smart contracts that power the peer-to-contract trades. Anyone can be a liquidity provider by depositing token pairs.
Why Are AMMs Important?
AMMs provide a safe (but not risk free), stable way to invest in crypto with strong returns for liquidity providers. These markets are self-sustaining because they don’t need intermediaries. Formulas power smart contracts that provide security and confidence for investors.
Algorithm-driven procedures allow anyone to become a liquidity provider or to trade crypto in a simple, clear manner. That’s not to say that investing on an AMM is without risks, because any form of investing has risks.
The Role of Liquidity Providers and Liquidity Pools
AMMs require liquidity to function. A liquidity pool allows many providers to pool together their assets using smart contracts. Traders can swap their digital assets using these pools. For example, a trader can use a BTC-USDC pool to either swap BTC for USDC or to swap USDC for BTC. Liquidity pools aid in avoiding large price swings for assets and AMMs hold the value of those assets using formulas that don’t rely on other traders.
What Is Impermanent Loss?
Impermanent loss can take place when a trader places their tokens within a liquidity pool and then the price changes. The value of those tokens is now less than it was at the time of the investment, which means if you remove them now, their value will have decreased.
However, these losses are impermanent until you remove the investment from the liquidity pool. You can wait to remove your liquidity until the exchange reaches a favorable point. And all the while, you’ll be earning transaction fees for allowing other traders to buy and sell using your liquidity.
Therefore, even if you end up losing some of the original value of the tokens you invested, you could come out ahead. The value of your tokens will continue to change until you sell your assets. Only then will your loss or increased value become permanent.
The concept mirrors unrealized gains and losses within the stock exchange. Although the price of a stock has gone up or down, you don’t realize those gains or losses until you sell the stock. All the while, you could be earning dividends on that investment that would offset losses if you sell the stock when its value is lower than when you invested.
Constant Product Formula
A constant product formula is one that does not change based on the size of the trade or asset that an investor is trading. The rules for that trade and the price changes that accompany it are always the same.
Most AMMs use a constant product market maker model. The formula for this model is X * Y = K. The formula requires that the total amount of liquidity remains constant. That’s the K in the formula. X and Y represent the two tokens being invested in the liquidity pool. The value of those two tokens must always be K. So as the value of Y increases, the value of X must decrease, and vice versa.
The formula dictates each transaction’s price regardless of how much of either token is bought or sold at any given point.
Avoiding or Minimizing Slippage
Slippage is the difference between the current market price of an asset and the price that your order is filled at. The impact of slippage will vary based on the formula that the AMM uses.
To avoid slippage, you should look for deep markets. That’s because fluctuations within liquidity pools occur more in smaller markets. So the more liquidity there is in a pool, the smaller impact trades will have on the value of the assets within that pool, decreasing your chances of experiencing slippage. Another solution is to trade on multiple exchanges. Institutional traders sometimes use a crypto trading api, coupled with smart order routing, to access liquidity on multiple exchanges to execute large-block trades.
Benefits of Automated Market Makers
Automated market makers have many great benefits that center around greater investment stability and clarity. Here’s a look at some of the top advantages of AMMs.
- Provide liquidity in the absence of other traders: because traders, both buyers and sellers, swap assets with a liquidity pool instead of other buyers and sellers.
- Diminish price manipulation tactics: because the formula holds the value of the token pairs constant, it reduces the ability for traders to use tactics like wash trading, front running and other price manipulation tactics
- Provide transparency : by making on-chain transactions and enabling traders to maintain custody of their assets when trading
Automated Market Makers vs Order Books
An AMM does not rely on a third party because these protocols rely on liquidity pools that make trades possible.
Order books can provide more advanced trading functions and fill orders at a specific price for buying and selling. It’s also easier to chart and analyze trades using an order book than it is within AMMs. The fact that you can place limit orders makes order books better for infrequent traders who don’t have time to watch the market for a certain price.
Hybrid Exchanges: CEX + DEX = HEX
Hybrid DEXs are now emerging that combine the advantages of both the CEX and DEXexchange models to deliver the best of both worlds.A hybrid exchange can also enble investors the opportunity to set stop loss orders to mitigate losses. In a Hybrid exchange, the AMM inserts orders into a Centralized Order Book, providing the convenience of centralized exchange trading with the predictable liquidity of AMM.
AMM Crypto Investment Strategies
Automated Market Makers offer an excellent way to get started investing in crypto while mitigating chances for loss. Liquidity pool investment can be a far more stable structure for getting started in crypto. And using a hybrid exchange like Apifiny HEX brings together the best of both order books and AMMs.
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