Automated Market Maker

Published on :

21 Aug, 2024

Blog Author :

Edited by :

Reviewed by :

An Automated Market Maker (AMM) is a type of algorithm that is created using blockchain technology. It automates the process of conducting trades in the decentralized exchanges. It operates on blockchains and uses smart contracts, due to which trades may be executed at any time, in a permissionless manner, and for substantially lesser fees.

AMMs use mathematical equations to maintain balance in assets in a liquidity pool. When a user chooses to trade on a decentralized trading platform, they perform it directly with the AMM by exchanging one token for another at a price established by the liquidity pool's algorithm.

What Is An Automated Market Maker (AMM)?

An Automated Market Maker is a specific kind of algorithm that is developed with the use of blockchain technology. It automates the trading procedure on decentralized exchanges.
It relies on blockchains and smart contracts, enabling trades to be completed at any period without requiring permission and for significantly lower fees.
AMMs impose minimal expenses, making the trading process more affordable and effective.
Algorithms are used to establish the prices of securities traded through AMMs. As a result, it minimizes certain financial risks.

Automated Market Maker Explained

Automated Market Makers (AMMs) are contract-based algorithms that optimize the virtual asset trading process. These exchanges operate in a decentralized method. They remove the requirement of order books to coordinate trades between buyers and sellers. AMMs are also considered to be liquidity providers, as they eliminate the need for an intermediary. Trading professionals use AMMs to generate liquidity by producing numerous purchase and sell orders.

AMMs are viewed as an essential component of the digital currency ecosystem. This framework facilitates decentralization and enhances trading by streamlining the use of digital assets. They enable users to execute transactions while eliminating the need for a third party. As a result, the trading strategies become transparent and reliable. Moreover, they offer accessibility since any individual with an active internet connection and a suitable wallet can access the system.

Models

The AMM models are as follows:

CPMM: The Constant Product Market Makers (CPMM) operates on the mathematical equation x * y = k. This algorithm calculates a price range for two tokens according to the amount that is available for each token in the pool. In order to retain the product constant, when the supply of one token rises, the supply of the other token must fall.
CSMM: The Constant Sum Automated Market Maker (CSMM) is not extensively employed. It is based on the formula x + y = k. This model is appropriate for zero-price-impact trades. However, it does not provide unlimited liquidity. The CSMM's linear pricing curve can be troublesome if the off-chain reference price among the tokens differs from the 1:1 ratio. It would result in draining one side of the liquidity pool and leave traders with no liquidity.
CMMM: The Constant Mean Market Maker (CMMM) permits over two tokens in a liquidity pool and offers weighted distributions that go beyond the usual 50/50 division. For a liquidity pool consisting of three assets, the equation is (x * y * z)^(1/3) = k. The system allows for varying exposure to different assets in the pool. It also allows exchanges between any assets in the pool.

Role Of Liquidity Pools And Liquidity Providers

Liquidity pools, a crowdsourced set of digital assets, act as the foundation for AMMs. AMMs employ liquidity pools to trade with individuals who purchase or sell these assets. Liquidity providers are users who deposit their assets into the liquidity pools.

AMMs cannot function successfully without liquidity. If an AMM lacks an adequate liquidity pool, traders that purchase and sell assets on the decentralized finance (DeFi) AMM might experience a substantial price effect. It may result in capital ineffectiveness and an irreversible loss. AMMs offer liquidity providers a small percentage of the AMM's fees, which often come in the form of LP tokens, in order to motivate them to deposit their digital assets with the protocol. Yield farming involves the process of submitting assets to earn incentives.

Examples

Let us go through the following examples to understand AMMs:

Example #1

Suppose there are two stablecoins named Cryptogain and Blockrex. A liquidity pool might encompass ten million dollars in Cryptogain and ten million dollars in Blockrex. Jake, a crypto trader, wants to swap $500,000 worth of his own Blockrex for Cryptogain. He follows the process and completes the transaction. As a result, there is an increase in the price of Cryptogain on AMM. This is how an automated market maker works.

Example #2

Decentralized exchanges, or DEXs, suffer from the constraints of AMMs. The AMM models have been playing a significant part in the DEX transformation. They have enabled a supply of liquidity without the need for traditional order books. However, they come with their own set of challenges. New users frequently find AMM non-intuitive and hard to comprehend, especially when they are dealing with highly volatile trading pairs. This is another automated market maker example.

Benefits

Some benefits of AMM include the following:

AMMs are a blockchain-based concept. So, they allow for decentralized and trustless transactions without the need for intermediaries. When employing AMMs, individuals are not required to sign up, provide personal information, or trust a third party with their assets. They only need a self-custody wallet.
AMMs provide traders with convenient access to a wide range of trading pairs that are not provided on traditional exchanges. Moreover, they offer liquidity pools that enable traders to trade multiple securities at once. Thus, they facilitate advanced trading strategies.
Since AMMs are based on open-source technology, they may be integrated into a wide range of DeFi protocols, including borrowing and lending.
The principal source of revenue for centralized exchanges is fees. Thus, they charge hefty prices for accessing their platforms. On the other hand, AMMs charge minimal costs, which makes trading cheaper and more effective.
The prices of securities that are exchanged using AMMs are established using algorithms. Thus, it avoids some of the financial risks associated with centralized exchanges, including frontrunning asset releases.

Challenges

There are some disadvantages to using AMMs. For instance, investors may suffer losses resulting from price slippage. Moreover, hackers may misuse these models. Additionally, unlike centralized exchanges, they do not have access to all marketplaces. Furthermore, compared to centralized exchanges, they often have fewer liquidity resources. AMM's complicated technicality may not be ideal for individuals who possess inadequate technical understanding.

Frequently Asked Questions (FAQs)

How is an automated market maker different from a traditional market maker?

The primary difference between AMMs and traditional exchanges is the absence of intermediaries. Traditional exchanges employ brokers, dealers, and clearinghouses to organize trades between sellers and buyers. These middlemen demand fees for their services, which increases the cost of trading. Moreover, AMMs use smart contracts to automate asset switching, which makes them less expensive and more effective than traditional exchanges.

What is a virtual automated market maker?

They are a new form of AMM that caters to facilitate direct trading of tokenized derivatives over the blockchain because of their synthetic liquidity. They were established on the principle of AMMs. It offers additional features, including derivatives and perpetual contracts. Usually, two different types of users participate in them. They are traders and liquidity providers, where liquidity providers issue tokens, which traders then swap.

Who created the first automated market maker?

Vitalik Buterin first developed the AMMs in 2017. The initial AMM models were introduced four years later. AMMs have enabled decentralized financing and significantly enhanced the potential of decentralized exchanges.