Automated market makers offer free tokens and a percentage of transaction costs in return for users providing liquidity.
Uniswap was the first decentralized platform to effectively use an automated market maker (AMM) mechanism when it went live in 2018.
All decentralized exchanges (DEXs), which enable users to swap cryptocurrencies by connecting users directly and eliminating middlemen, are powered by an automated market maker (AMM). Automated market makers are, to put it simply, autonomous trading systems that do away with the necessity for centralized exchanges and associated market-making procedures.
What is a market maker?
The procedure needed to provide liquidity for trading pairs on controlled exchanges is facilitated by a market maker. A centralized exchange supervises trader activity and offers an automated mechanism to make sure that trading orders are matched appropriately. In other words, the exchange makes sure it locates a Trader B who is prepared to sell 1 BTC at Trader A’s desired exchange rate when Trader A decides to purchase 1 BTC for $34,000. As a result, the centralized exchange serves as a sort of intermediary between Trader A and Trader B, ensuring that everything goes as smoothly as possible and quickly matching users’ buy and sell orders.
What happens then if the exchange is unable to instantly match acceptable purchase and sell orders?
In this case, we argue that the assets in issue have limited liquidity.
In terms of trade, liquidity refers to how quickly an asset may be purchased and sold.
A high level of liquidity indicates that the market is busy and that many traders are buying and selling a certain item. In contrast, low liquidity results in less activity and makes it more difficult to acquire and sell assets.
Slippages frequently happen when liquidity is limited. In other words, before a deal is closed, the price of an asset at the time of execution changes significantly. This frequently happens in risky environments, such as the crypto market. To prevent price slippages, exchanges must make sure that transactions are carried out immediately.
Centralized exchanges rely on experienced traders or financial institutions to supply liquidity for trading pairs in order to develop a fluid trading system. To match the orders of ordinary traders, these companies generate several bid-ask orders. This enables the exchange to guarantee that counterparties are constantly accessible for all deals. The liquidity providers act as market makers in this system. In other words, market makers help with the procedures needed to supply trading pairs with liquidity.
What is an automated market maker (AMM)?
DEXs, as opposed to centralized exchanges, aim to do away with all intermediary steps in cryptocurrency trading. Since they don’t enable custodial infrastructures (where the exchange keeps all of the wallet private keys) or order matching systems, DEXs encourage autonomy so that users may start trading right from non-custodial wallets (wallets where the individual controls the private key.)
AMMs, which are autonomous protocols, take the place of order matching systems and order books in DEXs. These protocols regulate the price of digital assets and offer liquidity via smart contracts, which are self-executing computer programs. The protocol in this case combines liquidity into smart contracts. In essence, users are trading against the liquidity that is locked inside smart contracts rather than actual counterparties. It’s common to refer to these smart contracts as liquidity pools.
Notably, on conventional exchanges, the position of a liquidity provider can only be held by high-net-worth people or businesses. AMMs can be any entity as long as it satisfies the criteria that are hardcoded into the smart contract. AMMs include things like Uniswap, Balancer, and Curve.
How do Automatic Market Makers (AMMs) operate?
First, it’s crucial to understand two facts concerning AMMs:
- Individual “liquidity pools” for trading pairs that you would typically see on a centralized exchange exist in AMMs. For instance, you would need to locate an ETH/USDT liquidity pool if you wanted to exchange ether for tether.
- By depositing both of the assets represented in the pool, anybody may supply liquidity to these pools in place of hiring specialized market makers. For instance, you would need to deposit a specific fixed ratio of ETH and USDT if you wanted to become a liquidity provider for an ETH/USDT pool.
There may be noticeable differences between an asset’s price in a pool and its market price (the price it is trading at across multiple exchanges) when large orders are placed in AMMs and a sizable amount of a token is removed from or added to a pool. For instance, the market price of ETH might be $3,000 but in a pool, it might be $2,850 because a lot of ETH was added to a pool in order to remove another token.
As a result, there would be an arbitrage opportunity as ETH would be trading at a discount in the pool. Liquidity is necessary for AMMs to operate efficiently. Slippages can happen in pools that are not appropriately supported. AMMs encourage users to deposit digital assets in liquidity pools so that other users can trade against these funds in order to reduce slippages. The protocol offers incentives by giving liquidity providers (LPs) a portion of the fees collected from transactions carried out on the pool. To put it another way, if your deposit equals 1% of the liquidity that is locked in a pool, you will receive an LP token that equals 1% of the pool’s collected transaction fees. A liquidity provider who wants to leave a pool must redeem their LP token in order to get their cut of the transaction fees.
The method of arbitrage trading involves identifying price disparities between an asset on several exchanges, purchasing it on the platform where it is slightly less expensive, and selling it on the platform where it is slightly more expensive.
Arbitrage traders for AMMs are financially motivated to locate assets that are trading at discounts in liquidity pools and purchase them up until the asset’s price reverts to its market price.
For instance, arbitrage traders can profit if the price of ETH in a liquidity pool is lower than its exchange rate on other markets by purchasing ETH in the pool at a cheaper price and selling it at a higher price on external exchanges. The price of the pooled ETH will steadily rise with each trade until it catches up to the going market rate.
Liquidity providers’ function in AMMs
Liquidity is necessary for AMMs to operate efficiently. Slippages can happen in pools that are not appropriately supported. AMMs encourage users to deposit digital assets in liquidity pools so that other users can trade against these funds in order to reduce slippages.
The protocol offers incentives by giving liquidity providers (LPs) a portion of the fees collected from transactions carried out on the pool. To put it another way, if your deposit equals 1% of the liquidity that is locked in a pool, you will receive an LP token that equals 1% of the pool’s collected transaction fees. A liquidity provider who wants to leave a pool must redeem their LP token in order to get their cut of the transaction fees.
Additionally, traders and LPs also receive governance tokens from AMMs. A governance token gives the possessor the ability to vote on matters pertaining to the management and advancement of the AMM protocol, as its name suggests.
Opportunities for yield farming on AMMs
In addition to the rewards mentioned above, LPs can benefit from yield farming options that promise to boost their revenues. You only need to deposit the right proportion of digital assets in a liquidity pool on an AMM protocol to take advantage of this benefit. You will receive LP tokens from the AMM protocol after the deposit has been verified. In some cases, you may then “stake” or deposit this token into a different lending mechanism to receive further interest.
By taking use of the composability or interoperability of decentralized finance (DeFi) protocols, you will have been able to optimize your profits. However, keep in mind that in order to withdraw money from the first liquidity pool, you will need to redeem the liquidity provider token.
What is impermanent loss?
Impermanent loss is one of the hazards connected to liquidity pools. When the price ratio of the pooled assets changes, this happens. When the price ratio of the pooled asset differs from the price at which the LP deposited funds, losses are automatically incurred. The loss suffered increases with the magnitude of the price change. Pools with variable digital assets are frequently impacted by impermanent losses.
Because there is a chance that the price ratio will change, this loss is temporary. Only when the LP takes the aforementioned funds out before the price ratio reverts does the loss turn into permanent. Note that such losses may occasionally be offset by prospective revenues from transaction fees and LP token staking.
