Automated market makers (AMM) use algorithms to price assets in liquidity pools, allowing for persistent, automated, and decentralized trading. Buyers, sellers, and a central reserve of assets are all required in traditional exchanges. AMM exchanges, on the other hand, crowdsource liquidity and execute deals using bots known as smart contracts. However, AMMs, like any new technology, come with certain drawbacks.
What is an AMM exchange?
AMMs (automated market makers) are decentralized exchanges that pool liquidity from users and employ algorithms to price the assets within the pool and allow digital assets to be traded in a permissionless and automatic way.
x * y = k — The Classic AMM Formula
Consider how AMM exchanges vary from regular exchanges to have a better understanding of them. Buyers and sellers must meet at an overlapping price point on a centralized order book in traditional exchanges. AMMs do a lot of things differently.
- Order books and buyers/sellers are replaced with crowdsourced liquidity pools.
- When purchasing cryptocurrency, an algorithm ensures that everyone pays the same price.
- Incentivize users to deposit crypto assets in liquidity pools through a technique known as yield farming.
- To provide everyone trading with the pool a consistent price, AMMs use an algorithm resembling x * y = k.
- Swap assets among traders. Smart contracts are used to automatically pool liquidity.
Let’s take a look at AMMs in more detail, starting with a brief history and explanation of how they function.
How did AMM Exchanges Begin?
There was just one decentralized exchange at one point: Ether Delta, which allowed you to trade directly with other crypto users in a style similar to early torrent applications.
Another exchange, ShapeShift, rose to prominence about the same period. ShapeShift, unlike Ether Delta, is centralized and holds crypto assets in reserve. It also only enables basic market purchases from its cryptocurrency reserve kept by the firm.
The Ether Delta exchange concept has one flaw: it is not capital efficient. At seller-determined prices, you must always locate a counterparty to your deal. ShapeShift and other centralized exchanges fulfill the maker function in every exchange transaction, narrowing the bid/ask spread, but you are obliged to trust them.
Vitalik Buterin, the creator of Ethereum, posted a remark on Reddit in 2016. Using an x * y = k method, he described a technique for on-chain decentralized exchanges. The method, also known as the XYK model, is the foundation for the Uniswap-popularized liquidity pool pairings.
In a long-forgotten blog post the next year, the Gnosis team concretely conceived the AMM paradigm. Gnosis looks to be the first to sketch out an AMM DEX, while Bancor was the first to put the idea into action, raising $153 million in an ICO to construct a completely on-chain DEX.
Bancor’s huge ICO put the project in a prime position to launch a functional and widely used DEX. The true victor of the AMM exchange competition, on the other hand, came from an unusual source.
The Ethereum Foundation awarded Uniswap, an unknown initiative, a $100,000 grant in 2018. Due to two creative tweaks, Uniswap was contending with Bancor’s trading volumes within several weeks. Uniswap was significantly more gas efficient (and hence less expensive to operate) than Bancor, and the common pair for all tokens was ETH.
With a high focus on gas efficiency and ETH-paired pools, Uniswap was immediately embraced and bootstrapped liquidity from a large number of ETH holders. Uniswap had acquired such a following by 2021 that daily transaction volumes of $1 billion became the new standard.
Other DeFi exchanges soon found markets for new applications because of the popularity of Uniswap’s AMM architecture, easy swap UI, and bottomless liquidity. Curve trades stablecoins using the AMM concept, whereas Balancer’s AMM creates liquidity pools from more than two assets.
How does an AMM DEX Work?
It’s simple to understand how AMM swaps operate. An AMM protocol works as a robot concierge, delivering transactions between you and a liquidity pool backed by liquidity providers (LPs). You can perform a variety of roles in the AMM model, including trader, liquidity provider, and protocol governor. The protocol itself only prices assets and uses smart contracts to execute transactions.
Assume you’re using EmiSwap to buy ETH tokens with ESW tokens. When you press the swap button, the algorithm does certain calculations to determine how your trade will affect the liquidity pool’s reserves, and then provides you with a price quote.
The smart contract puts your ESW tokens into the ETH-ESW pool when you accept the transaction. Finally, the pool delivers the specified amount of ETH to your wallet.
In AMM protocols, methods like the x * y = k models are used to price assets. The (x) and (y) values represent the same number of assets in the pool, and (k) is the entire or constant quantity of liquidity in the pool.
Let’s reconsider how an ETH-ESW transaction works using this formula.
To purchase ETH (x) on EmiSwap, you must first deposit ESW(y) tokens in the pool. Keep in mind that (k) requires that the volume of liquid stay constant. As a result, adding ESW tokens increases one side of the pool while lowering the other (removing ETH).
The algorithm divides the entire liquidity of the pool by the new amount of ESW in the pool, then divides that by the new amount of ETH in the pool, resulting in (k / y) / x = price. This is how the protocol decides your ETH price, which will rise as you buy more ETH from the pool.
In principle, the greater the advertised price for the requested asset, the larger your order. During high-volume trading periods, the same is true. This is because AMMs rely on matched assets being pooled together and priced using an algorithm. Furthermore, a larger price gap between assets might increase the chance of slippage.
Impermanent losses are incurred by liquidity providers that deposit paired crypto assets in a liquidity pool. If the price of one or both of your assets changes, you may withdraw less of your assets than you placed. The danger of impermanent loss is reduced by using AMM protocols like Curve, Sushi, and EmiSwap to deposit pairs of stablecoins (which retain a more or less identical value).
Smart Contract Risk
When you join an AMM protocol as a liquidity provider, you’re depositing crypto into a smart contract. What if a glitch or a hacker takes advantage of the smart contract? Sadly, this might result in the total loss of your cryptocurrency. Many DeFi protocols, such as Compound, Aave, Yearn Finance, and EmiSwap retain a substantial compensation reserve in case of an emergency.
What makes AMMs so special? They allow several key DeFi capabilities that conventional exchanges are unable to match. Here are a few of their perks.
AMMs do not need sign-ups, KYC procedures, or other trading barriers. Anyone with a crypto wallet and access to the internet may trade at any time. Despite unprecedented trading volumes, AMM exchanges maintained 100% uptime throughout the devastating May 2021 crypto meltdown, whereas centralized exchanges like Coinbase, Binance, and Robinhood all fell.
Balancer, one of the newer AMM DeFi protocols, uses dynamically weighted liquidity pools to improve capital efficiency, resulting in reduced slippage and better pricing during high-volume trading.
Liquidity is provided by large market makers on centralized exchanges. AMM exchanges obtain liquidity by crowdsourcing it from anybody willing to deposit their assets in exchange for a portion of the trading fees. The effectiveness of democratizing the backend of exchanges in this way can be seen in the fact that more than $80 billion in assets have been locked into DeFi.
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