If you're a cryptocurrency trader you probably know that: Of all the Defi innovations Automated Market Maker (AMM) stands out. AMM-based decentralized exchange (DEX) that has proven to be innovative Defi have the biggest impact.
AMM allows creating and running liquidity so that you can access many different tokens. So let's find out what is AMM? How does it work? Risk limitations to pay attention to if AMM is interested.
Automated Market Maker (AMM) price, marketcap, chart, and fundamentals info
Automated Market Maker, or AMM, is a tool that often works on a decentralized exchange that relies on mathematical formulas to price tokens. Like regular exchanges, they have many different trading pairs.
There are no buy or sell orders and traders don't need to find someone else to sell their money. Instead, the smart contract acts as the creator of an exchange transaction. The reserves are replaced by pools based on smart contracts.
The liquidity pool contains two assets in a trading pair. The relative ratio (%) of each token in the pool is what determines the theoretical price of the particular asset. The first direct AMM is Bancor, launched in 2017. But today's most popular platforms are Uniswap, Curves, Kyber and Balancer.
Why do these exchanges exist?
AMM is addressing the performance constraints of blockchain smart contracts, especially Ethereum. Before AMM became famous, DEX exchanges built on top of Ethereum, like EtherDelta or 0x, tried to use the classic order book mechanism.
However, they ran into liquidity problems. Because placing each order requires fees gas and wait for block confirm time. Ethereum's low throughput also means that only a small number of transactions can be sent before the blockchain is completely covered by these orders.
This is especially problematic for market makers, Liquidity Provider (LP) on order book exchanges. Creating a market often requires constant adjustment of buy and sell orders according to the latest price. When each order is deposited costs money and time, they can lose more money than they can get from the difference between the bid and ask.
AMM helps provide cheaper and simpler liquidity through a fully auto one-time process. Even users with little knowledge can engage with their liquidity. While doing so on traditional exchanges requires advanced technical knowledge.
How do smart contracts automate transactions on AMM?
When trading on AMM, the user interacts with the liquidity pool. Basically, when the user instructs the smart contract to perform the transaction. Contract will send their tokens like ETH to the pool. Then a formula will decide how many tokens there are from the other side of the pair.
The simplest formula is: X * Y = K, where X, Y represent the quantity of each token in the pool. K is a predefined constant. This equation defines a hyperbolic, geometric form that approaches both infinity and zero at its extreme points but never reaches them.
Each trade has a slippage (the size of the order affects the final price at which tokens are bought, sold). The hyperbolic shape means the slippage will be low on small orders. But with large orders, the slippage will increase exponentially.
Uniswap is known for using this simple formula. Other platforms may use more complex math to correct slippage.
How to use Automated Market Maker?
Using the AMM protocol is quite simple:
- The user accesses the protocol's site or the user interface.
- Connect a DeFi enabled wallet to the protocol, choose the assets they want to buy and sell
- Click "swap”And confirm the transaction on their wallet.
Providing liquidity works similarly to trading:
- After connecting the wallet, users can go to the "Liquidity Provider".
- Choose the amount they want to commit to the pool. For most protocols, they should have both types of properties available. Example: If ETH costs 450 DAI, brothers need to provide 1 ETH and 450 DAI at the same time.
After confirming the transactions, users receive tokens representing their ownership in the pool. It can then be passed on to anyone or “swap” again for the underlying tokens, plus any fees they may have accrued.
Why is AMM so popular?
AMM is said to have solved the biggest obstacle to the wide adoption of DEXs, “Liquidity”. Without that problem, the natural benefits of DEX can be overcome.
Unlike a centralized exchange, there is no controller that can rule out the project or users. AMM does not require users to set up specific accounts or KYC. A wallet address is all that is needed to interact with protocols.
From a project's point of view, DEX is also a great way to release tokens to the market and bootstrap liquidity. With no listing fees, anyone can set up a liquidity pool for any token.
Project holders can help create a liquid market on new tokens. They do not need specialized Market Marker support.
Finally, the AMM DEXs often have a very simple interface. They don't need to pack advanced order options or chart prices into a Dashboard.
What are the risks and limitations of AMM?
AMM has certain risks and limitations such as:
- Attacks and security vulnerabilities affect exchanges such as Uniswap and Balancer, where some Liquidity Providers find their money stolen due to smart contract interactions.
- Traders are revealing their strategies to everyone. That is, allowing forecasts to take orders first and exploit legitimate users.
Nor would AMMs exist without traditional exchanges that are relied upon for arbitrage. The arbitrage traders are needed to adjust the pricing of assets in the AMM. But this leads to impermanent loss on many platforms.
In short, arbitrage makes a profit by bringing prices back to equilibrium, but these profits are extracted from the LPs. LPs can lose money if the price moves too far in a certain direction. An impermanent loss occurs because the price can always move in the opposite direction. In practice, this will not always happen.
Despite certain improvements, AMM volume and liquidity are still low compared to the largest centralized exchanges. Gas congestion in 2020 also shows that they are starting to reach peak utilization rates and better scaling solutions will be required in the future to facilitate further growth.