What is an automated market maker (AMM) in the crypto-currency industry?

It can take some time to understand how everything works in the crypto currency industry. This can certainly be the case with digital asset trading, where a number of different basic tools and additional features are used in the process. One such tool is the Automated Market Maker (AMM), which is now used daily by traders to make trades.

Decentralized finance (DeFi) has also seen a significant increase in interest in the Ethereum network and on other smart contract platforms. Earning payment has become a popular way to distribute tokens, and the BTC token is experiencing significant growth over Ethereum.

Meanwhile, automated market maker protocols such as Uniswap are steadily experiencing competitive volumes, high liquidity and a growing number of users. Check What are crypto currency liquidity pools? Why is this so important to DeFi?

But what is an automated market maker and can it help you?

One of the main desires of many crypto-currency holders is to trade untrusted (an untrusted system means that participants do not need to know or trust each other or a third party for the system to work). Unfortunately, third parties and central authorities can be problematic and time-consuming to fund, so decentralized funding services (DeFi) are designed to eliminate these problems. This is where an automated market maker helps.

An automated market maker is a digital tool or protocol for a decentralized financial system that relies on a mathematical equation to value assets.Instead of using a list of demands like traditional trading platforms, assets are valued based on a pricing algorithm. It is used to facilitate crypto currency transactions that are unreliable, i.e. without third parties. While it is not used by all crypto currency exchanges, it is used by all decentralized crypto currency exchanges (DEX). However, many of today’s major crypto exchanges, such as Coinbase and Kraken, do not use a decentralized model, which may be a stretch for some, as the whole idea of crypto-currencies is largely based on decentralization.

So if you want to use a completely decentralized exchange, you will connect to an automated market maker.

Uniswap, the first decentralized exchange to launch a successful automated market maker, was located on the Ethereum blockchain. Since its launch in 2018, the automated market maker has become increasingly popular in the DeFi world.

You won’t find an automated market maker anywhere outside the DeFi industry. It is essentially an alternative to the typical order books used by regular exchanges. Instead of one user providing a price to buy an asset from another user, AMM steps in and prices the asset as accurately as possible. How does this work? Check Explain the main crypto currency fees and how they cost you money.

How does an automated market maker work?

An automated market maker relies on mathematical functions to automatically value assets without human intervention. Liquidity pools play another major role in this process.

On a crypto-currency exchange, a single pool of cash contains a large amount of assets locked in a smart contract. The primary purpose of these locked tokens is to provide liquidity, hence the name. Liquidity pools require liquidity providers (i.e., asset providers) to create a market.

These cash pools can be used for several purposes, such as yield cultivation and borrowing.

Within liquidity pools, two different assets come together to form a trading pair. For example, if you see two adjacent asset names separated by a slash (e.g. USDT/BNB, ETH/DAI) on a decentralized exchange, you are looking at a trading pair. These example pairs are the ERC-20 tokens on the Ethereum blockchain (as on most decentralized exchanges).

The ratio of the amount of one asset to another in a trading pair does not have to be equal. For example, a pool may contain 80% Ethereum and 20% Tether, resulting in a total ratio of 4:1. But pools can also have equal proportions.

Anyone can become a market maker by depositing a predetermined percentage of two assets within a trading pair into the aggregator. Traders can trade the assets against the pool of liquidity instead of directly with each other.

Different decentralized exchanges can use different AMM functions. Uniswap’s AMM uses a fairly simple formula, but it was nevertheless very successful. In its simplest form, this formula looks like “x * y = k”. In this formula, “x” is the amount of the first asset in the liquidity pool and a trading pair, and “y” is the amount of the other asset within the same pool and the same pair.

With this specific formula, any given pool that uses AMM must maintain the same total liquidity on a constant basis, which means that the “k” in this equation is constant. Other DEXs use more complex functions, but we won’t go into that today.

Traditional market making usually works with companies that have huge resources and complex strategies. A market maker helps you get a good price and a limited bid-ask spread on a request list-based trading platform like Binance. An automated market maker decentralizes this process and allows anyone to create a market on the Blockchain. Check Decentralized Finance: what is yield farming and why is it so popular?

Benefits of an automated market maker

As mentioned earlier, AMM can dispense with the broker and make DEX trading completely unreliable, which is a valuable feature for many crypto currency holders.

AMM also encourages users to provide liquidity to pools. If an individual provides liquidity to a particular pool, he or she can earn passive income through transaction fees for other users. This financial lure is the reason for the multiplicity of liquidity providers in DEX.

For this reason, AMM is responsible for providing liquidity to the stock market, which is really its bread and butter. Therefore, in DEX, AMM is essential.

In addition, liquidity providers can also benefit from performance farming via MAs and liquidity pools. This involves a person leveraging their crypto currency to receive the assets of the liquidity pool in exchange for providing liquidity. Service providers can also move their assets between pools to increase their returns. These returns are usually in the form of an annual percentage rate (APY).

Disadvantages of an automated market maker

While MA is very useful, it can give way to some drawbacks, including slippage, which occurs when there is a difference between the expected price of a digital asset and the price of the asset at which the execution ends. This is mitigated by increasing the amount of fluidity in a particular complex.

In addition, MAs and cash pools are also associated with non-permanent losses. This involves losing money due to fluctuations within a trading pair. This volatility refers to the price of one or both assets within the pair. If the value of the assets at the time of withdrawal is less than what it was on deposit, the holder has suffered a non-permanent loss.

Non-permanent loss is a common problem in all DEX, as crypto-currencies are volatile and unpredictable in nature. However, in some cases, the asset will recover from a drop in price, which is why this type of loss in value is called “non-permanent”.

A non-permanent loss occurs when the rate of the deposited chips changes after they are deposited in the pool. The greater the change, the greater the non-permanent loss. This is why an automated market maker works best with a pair of tokens of similar value, such as stable coins or indexed tokens. If the average price between the trading pair stays within a relatively small range, the non-permanent loss is also small. Check out How to start a career in the crypto-currency industry.

The automated market maker maintains the operation of DeFi

While an automated market maker can be very beneficial in DEX, it certainly poses some risks to traders and investors. That’s why it’s always important to understand which DeFi service you want to use before offering your money. This way, you can be as prepared as possible for unexpected price drops or crashes. You can now view What is the bear and bull trap in crypto currency? How can I avoid it?