What Is an Automated Market Maker (AMM)?

Tanya Sharma
Tanya Sharma Published on January 31, 2023 07:13 AM

An automated market maker (AMM) is a sort of decentralized exchange (DEX) technology that prices assets using a mathematical formula. We will look at market makers, AMMs working, and the role of liquidity providers in AMMs in this guide.

automated market maker (AMM)
Source: Unsplash

An automated market maker (AMM) can be thought of as a robot that is always eager to offer you a price between two assets. Some, like Uniswap, use basic formulas, whereas Curve, Balancer, and others use more intricate ones.

You can not only trade with confidence while utilizing an AMM, but you can also become the house by providing liquidity to a liquidity pool. This essentially lets anyone become a market maker on an exchange and earn fees for supplying liquidity.

Because of how simple and straightforward they are to operate, AMMs have really carved themselves a niche in the Defi arena. Decentralizing markets in this manner is fundamental to the crypto concept.

Ethereum and other smart contract systems, such as BNB Smart Chain, have experienced a surge in interest in decentralized finance (DeFi). Yield farming has grown in popularity as a method of token distribution, tokenized BTC is increasing on Ethereum, and flash loan volumes are increasing.

Meanwhile, automated market maker protocols such as Uniswap see excellent liquidity, competitive volumes, and an expanding number of customers.

But how do these interactions work? Why is it so quick and simple to establish a market for the latest food coin? Can alternative market makers truly compete with established order book exchanges? Let us explore.

What is an automated market maker?

AMMs are a sort of decentralized exchange (DEX) that use algorithmic "money robots" to make it simple for independent traders to purchase and sell crypto assets. Users trade directly through the AMM rather than with other people, as they would with a regular order book.

Market makers are entities entrusted with creating liquidity for a traded asset on an otherwise illiquid market. Market makers accomplish this by buying and selling assets on their own accounts with the purpose of profiting from the spread—the difference between the highest buy offer and the lowest sell offer. Their trading activity generates liquidity, which helps to mitigate the price impact of larger trades.

While various types of exchange (DEX) designs exist, AMM-based DEXs have grown in popularity due to their ability to provide deep liquidity for a wide spectrum of digital assets.

How does an automated market maker (AMM) work?

An AMM functions similarly to an order book exchange in that there are trading pairings, such as ETH/DAI. To make a transaction, however, you do not need to have a counterparty (another trader) on the opposite side. You interact with a smart contract instead, which "creates" the market for you.

Trades take place directly between user wallets on a decentralized exchange like Binance DEX. If you sell BNB for BUSD on Binance DEX, someone else is purchasing BNB with their BUSD on the other side of the exchange. This is referred to as a peer-to-peer (P2P) transaction.

AMMs, on the other hand, can be thought of as peer-to-peer transactions (P2C). There is no need for traditional counterparties because trading takes place between users and contracts. An AMM has no order types because there is no order book. 

Instead, a formula determines the price you receive for an asset you want to buy or sell. However, it is worth mentioning that some future AMM designs may overcome this constraint.

So there are no counterparties required, but someone must still construct the market, right? Correct. The liquidity in the smart contract must still be given by users known as liquidity providers (LPs).

What Are Liquidity Pools and Liquidity Providers?

AMMs are supported by liquidity pools, which are crowdsourced collections of crypto assets that the AMM uses to trade with people who are buying or selling one of these assets. Users who deposit their assets in the pools are referred to as liquidity providers (LPs).

AMMs require liquidity to work correctly. When traders buy and sell assets on the DeFi AMM, a lack of liquidity in the AMM can cause a big price impact, resulting in capital inefficiencies and temporary loss.

To encourage liquidity providers to deposit their crypto assets on the system, AMMs reward them with a portion of the AMM's fees, which are often given as LP tokens. To encourage liquidity providers to deposit their crypto assets on the system, AMMs reward them with a portion of the AMM's fees, which are often given as LP tokens. Yield farming is the activity of putting assets in order to obtain incentives.

The prices of assets on an AMM adjust automatically based on demand. A liquidity pool, for example, may store ten million dollars in ETH and ten million dollars in USDC. A trader may then exchange $500k of their own USDC for ETH, raising the price of ETH on the AMM.

What Are the Different Models of Automated Market Makers (AMM)?

Constant function market makers (CFMMs), also known as constant product market makers, constant sum market makers, and constant mean market makers, are a type of first-generation AMM that have been popularised by protocols such as Bancor, Curve, and Uniswap.

These AMM exchanges are based on a constant function, which requires that the combined asset reserves of trading pairs remain constant. User deposits for trading pairs are pooled within a smart contract that any trader can use for token swap liquidity in non-custodial AMMs. Users trade against the smart contract (pooled assets) rather than with a counterparty directly, as in order book exchanges.

Constant Product Market Maker (CPMM)

The constant product market maker (CPMM), popularised by the first AMM-based DEX, Bancor, was the first type of CFMM to emerge. CPMMs are based on the function x*y=k, which determines a price range for two tokens based on their available amounts (liquidity).

To maintain the constant product K, as the supply of token X increases, the supply of token Y must decrease, and vice versa. When plotted, the outcome is a hyperbola with constant liquidity but growing prices that approach infinity at both ends.

Constant Sum Market Maker (CSMM)

A constant sum market maker (CSMM) is the second type, which is appropriate for zero-price-impact trades but does not provide unlimited liquidity. When plotted, CSMMs follow the formula x+y=k, which results in a straight line. Unfortunately, if the off-chain reference price between the tokens is not 1:1, arbitrageurs can drain one of the reserves.

In such a case, one side of the liquidity pool would be destroyed, leaving all of the liquidity in just one asset and, as a result, no more liquidity for traders. As a result, CSMM is a model that AMMs rarely employ.

Constant Mean Market Maker (CMMM)

The third form is a constant mean market maker (CMMM), which allows for the development of AMMs with more than two tokens and is weighted differently from the normal 50/50 distribution. The weighted geometric mean of each reserve remains constant in this model.

The calculation for a liquidity pool with three assets would be (x*y*z)(13)=k. This provides for varying exposure to different assets in the pool as well as swaps between any assets in the pool.

Challenges with First-Generation AMM Models

Many first-generation AMMs are constrained by temporary loss and low capital efficiency, affecting both liquidity providers and traders.

Impermanent Loss

The difference in value over time between putting tokens in an AMM and just retaining those tokens in a wallet is referred to as impermanent loss. When the market price of tokens within an AMM diverges in either way, this loss occurs.

Because AMMs does not automatically modify their exchange rates, an arbitrageur is required to acquire underpriced assets or sell overpriced assets until the AMM's prices equal the market-wide pricing of external marketplaces. Arbitrageurs' profits are taken from the pockets of liquidity providers, resulting in a loss.

Inadequate Capital Efficiency

To achieve the same level of pricing impact as an order book-based exchange, traditional AMM designs require a high quantity of liquidity. This is because a significant chunk of AMM liquidity is only available when the pricing curve begins to turn exponential. As a result of the significant price impact, most liquidity will never be employed by logical traders.

Because AMM liquidity providers have little influence over which price points are supplied to traders in this situation, some individuals refer to AMMs as "lazy liquidity" that is underutilized and poorly provisioned.

Meanwhile, market makers on order book exchanges have complete control over the prices at which they purchase and sell tokens. This results in extremely high capital efficiency at the expense of demanding active participation and control of liquidity provisioning.

Improving AMM Models Through Hybrid, Dynamic, Proactive, and Predictive

Virtual Services Innovative initiatives with novel design patterns, such as hybrid automated market makers, dynamic automated market makers, proactive market makers, and virtually automated market makers, are overcoming the aforementioned restrictions.

Hybrid CFMMs

As AMM-based liquidity has evolved, we have seen the creation of complex hybrid CFMMs, which combine several functions and parameters to achieve certain behaviors, such as reduced price effect for traders or altered risk exposure for liquidity providers.

Dynamic Automated Market Maker (DAMM)

Sigmadex combines Chainlink Price Feeds and implied volatility in a dynamic automated market maker (DAMM) methodology to help dynamically allocate liquidity along the price curve. It can produce a more robust market maker that reacts to changing market conditions by adding various dynamic variables into its algorithm. 

Sigmadex can concentrate liquidity near the market price during periods of low volatility to promote capital efficiency and then expand it during periods of high volatility to help shield traders from impairment loss.

Proactive Market Maker (PMM)

DODO is also utilizing a proactive market maker (PMM) strategy to boost liquidity on its protocol, which replicates the human market-making behaviors of a classic central limit order book.

The protocol employs globally accurate market prices from Chainlink Price Feeds to modify the price curve of each asset proactively in reaction to market movements, improving liquidity near the current market price. Finally, this allows for more efficient trading and lowers the impairment loss for liquidity providers.

Final thoughts

Automated market makers are a mainstay of the DeFi industry. They allow virtually anyone to construct marketplaces in a seamless and effective manner. While they have limits when compared to order book exchanges, the overall innovation they provide to cryptocurrency is priceless.

AMMs are still in their early stages. The AMMs we know and use today, such as Uniswap, Curve, and PancakeSwap, are attractive in form but feature-limited. There will very certainly be many more inventive AMM designs in the future. This should result in lower fees, less friction, and, eventually, improved liquidity for all DeFi users.

Automated Market Maker FAQs

What is an AMM?

An automated market maker (AMM) allows digital assets to be purchased and sold on a decentralized exchange (DEX) at market pricing without the need for a middleman.

What is Amm trading?

Automated market makers (AMM) are decentralized exchanges that pool liquidity from users and employ algorithms to price assets within the pool.

Does Binance use AMM?

Binance has announced the creation of a "centralized" automated market maker (AMM) pool for liquidity providers. The AMM pool, called Binance Liquid Swap, will have several liquidity pools with rapid token swap capability.



XLM Price Prediction as Bitstamp Integrates USDC Via Stellar
XLM Price Prediction as Bitstamp Integrates USDC Via Stellar
October 04, 2023 01:46 PM