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- 1 Automated market makers have become a significant part of decentralized exchanges.
- 2 They offer a distinct ecosystem for bringing liquidity.
- 3 They also provide some other opportunities to traders.
Automated Market Maker is a particular mechanism that uses algorithms to bring liquidity. Many experts refer to them as decentralized exchanges as well. It is only DEXs that deploy this method to facilitate the process of buying and selling.
However, there are a lot of AMMs that one needs to understand. They have a full-fledged system that makes them quite sophisticated. So, let’s dive into the world of automated market makers right away.
Automated Market Maker: A Detailed Explanation
In 2018, Uniswap became the first decentralized platform to introduce an automated market maker. Centralized exchanges deployed market makers for a very specific purpose.
A market maker facilitated the process of bringing liquidity for trading pairs. It automated the system of matching the trade order for exchanges. For instance, suppose that Mr. X wants to sell 1 BTC at $35,000. The market maker will ensure that he finds a buyer who agrees to buy BTC at that price.
In the centralized exchange scenario, the market maker acts as a middleman between traders. When it comes to decentralized exchanges, there’s a little difference here. It is because DEXs’ attempt to eliminate the intermediaries. Moreover, they don’t support any custodial infrastructure or an order-matching system.
Instead, DEXs emphasize implementing autonomy in the entire process. They enable users to initiate trades without depending on custodial applications. So, they adopt automated market makers equipped with autonomous protocols or smart contracts.
In this case, users are introduced to a whole new system of trading. They don’t really buy/sell cryptos from counterparties here. Instead, they deal with smart contracts loaded with liquidity. In a centralized environment, any individual or entity with a high net worth can become a liquidity provider.
For AMMs, it all depends on the conditions mentioned in the smart contract. Some major platforms that use AMMs are Curve, Balancer, and Uniswap.
Insight Into The Functionality of Automatic Market Maker
In AMMs, trading pairs exist as individual “liquidity pools”. For example, if someone wants to trade Ether or Tether, they would require an ETH/USDT liquidity pool. Furthermore, anyone can bring liquidity to these pools by depositing both assets. In that case, they won’t have to depend on dedicated market makers.
Hence, anyone can become a liquidity provider for the ETH/USDT pool by depositing both tokens in it. To ensure a balanced proportion of assets in liquidity pools, AMMs use mathematical equations. These equations are predetermined to rule out any discrepancies.
Uniswap and some other exchanges have x*y=k for this purpose.
X= value of 1st asset
Y= value of 2nd asset
K= constant
With this arrangement, exchanges balance the number of assets available in liquidity pools. To understand it better, let’s look into the ETH/USDT liquidity pool. In the case of ETH purchase by a trader, USDT is added to the pool while ETH is removed. Since USDT is added to the pool, its price is adjusted as per the balancing equation.
The same will happen in reverse when someone purchases ETH. When large orders are placed, they cause a disbalance between assets’ prices in the pool and in the market. For instance, the ETH might be $3000/token in the pool depending on its availability. On the other hand, it could be $2850/token in the market.
This scenario paves the way for arbitrage trading in the market. Arbitrage trading is all about finding and leveraging the differences in the assets’ prices. Traders buy a certain asset from an exchange that’s selling it at a low price. Then, they sell it on an exchange where it is bidding at a higher price.
In the AMM environment, arbitrage traders gain advantages in finding discounted assets. For instance, say ETH is available at a lower price in the pool compared to the market. The traders can buy it from the pool and sell it on an exchange turning a profit.
On the other hand, the liquidity pool will start to gather more ETHs. Ultimately, its price will match that of the markets. Crypto users should remember that x*y=k is just one such mathematical formula used by AMMs. There are other exchanges that use more complex formulas.
Closing Thoughts
Automated market makers bring other opportunities for traders as well. The liquidity providers on AMMs can capitalize on yield farming to enhance earnings. To gain that benefit, LPs need to deposit a commensurate ratio of digital assets. At the same time, they should know about the associated risks of AMMs.
Impermanent loss is one possibility that occurs when the price ratio of pooled assets fluctuates. The higher the fluctuation, the more the losses. The loss can be recovered with the restoration of prices. Thus, using a DEX with AMM is useful, but one should know all about it.
Steve Anderson is an Australian crypto enthusiast. He is a specialist in management and trading for over 5 years. Steve has worked as a crypto trader, he loves learning about decentralisation, understanding the true potential of the blockchain.
