Automated Market Maker (AMM)

Automated Market Makers (AMMs) represent a type of decentralized exchange that leverages an algorithm to quote the price between two crypto assets. 

They do not make use of order books unlike centralized exchanges, and are way simpler and easier to use. 

 AMMs provide a consistent way to trade crypto assets without hoping for counterparties with matching offers which is obtainable in centralized exchanges and order-book based Dexs.

Centralized exchanges and order book based DEXs are characterized with order books where users set buy and sell orders at either market prices or their desired limit prices. You can call this a peer-to-peer model while AMMs leverage smart contracts to quote the prices of assets without the need for an order book. This innovation follows the peer-to-contract model. The absence of order books in AMMs is replaced by liquidity pools where users/liquidity providers (LPs) pool their resources to provide liquidity for various crypto assets, and in turn earn trading fees. 

Liquidity providers create a market by depositing an equivalent value of two tokens. These can either be ETH and an ERC-20 token or two ERC-20 tokens. These pools are commonly made up of stablecoins such as DAI, USDC, or USDT, but this isn’t a requirement. 

In return, liquidity providers get “liquidity tokens,” which represent their position in the entire liquidity pool. These liquidity tokens can be redeemed for the position they represent in the pool.

The first protocol to leverage this mechanism is Uniswap – a decentralized and trustless protocol built on the Ethereum network and designed to swap between ERC-20 tokens with a ridiculously low slippage. 

Uniswap was created by Hayden Adams in 2018 and functions with a design called the Constant Product Market Maker (a variant of AMM). 

The formula reads thus: x * y = k. 

Where x represents one portion of the assets in a particular liquidity pool (e.g. ETH) in an ETH/DAI liquidity pool. 

y represents the other portion of the asset in the liquidity pool (e.g. DAI) in the ETH/DAI liquidity pool. 

k represents constant. 

Hence, the formula depicts the multiplication of equal amounts of the 2 assets – in this case, ETH (x) & DAI (y) to provide everyone trading with the pool a constant (k) price. 

For example, when a user makes a purchase of ETH with DAI from an ETH/DAI liquidity pool, the amount of ETH in the pool decreases while the amount of DAI increases (since DAI was used in making the purchase). 

This tells the pool’s algorithm to adjust the price ratio between the two assets accordingly, so that the x*y = k formula is maintained.

 Some protocols like Curve Finance, Balancer use more complex formula, but the underlying principle remains the same and it ensures that, as long as there is sufficient liquidity in the pool, users can count on getting a quote price for their desired trade. 

Besides the constant product market maker formula, there are other variants of AMM formulas currently in use by several AMM-based decentralized exchanges. 

However, the constant product market maker formula used by Uniswap is the most common AMM formula in use. 

Risks of using AMM

  • Slippage: This happens when there are large orders and possibly not enough liquidity in the pool to execute. So, pools with lower liquidity will suffer high price slippages on large orders.

Impermanent loss : This is the loss in dollar value of your deposited assets in a liquidity pool compared to when you deposited them. Liquidity providers should beware of Impermanent loss before providing liquidity to AMM-based DEXs.

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