What is an AMM (Automated Market Maker)?
Last Update: March 8th, 2022
Automated Market Makers or AMM is the fundamental cornerstone in any cryptocurrency pair. These protocols help DeFi exchanges by providing speed and capital in the markets they are trading. AMMs are the backbone for the entire cryptocurrency ecosystem to work because they provide liquidity so anyone can buy and sell their cryptocurrency tokens seamlessly.
What is Market Making?
To understand how AMMs work, we first need to understand how traditional market making works in the traditional financial markets.
Most financial market exchanges, including the cryptocurrency market, work using the “order book” model. This model basically creates a list of all the buyers and sellers along with their desired buying/selling prices and the corresponding volume they are willing to buy/sell. Next, they match the buy and sell orders that have the same prices together with each other. Once matched, a trade is executed and the transaction is complete.
Now, the problem occurs when there are no matching buy and sell orders. Markets can become slow and inefficient if market participants do not want to buy up or sell down to create a trade. This is what you call an illiquid market.
Trading is very inefficient because it is hard to match buy and sell orders if market participants are either few or simply do not want to buy or sell at a higher or lower price – instead are just willing to wait for someone to buy/sell at their desired price. Or if you really want to buy/sell immediately, you would have to get it at a discounted price which could result in you taking a large loss in your position which in turn significantly changes the market price of the asset. An illiquid market is usually a turn-off for investors because it will be hard for them to get in and out of a trading position and often cause trading slippage.
This is where “market-making” comes into play. The market maker creates liquidity by buying or selling an asset without drastically changing the price. They make trading financial assets faster and easier for market participants. They quote the buy and sell prices such that the spreads or slippage are not too far from each other. They essentially, “make the market’ by being the conduit between the buyers and sellers. They either use their own capital or the capital of investors as liquidity to buy and sell the market. Without these market makers, the trading experience of various financial exchanges would be very slow and expensive as the order book model is simply tedious to implement if there are too few participants in it.
How does Automated Market Making (AMM) work?
Now, Automated Market Makers (AMM) are simply faster and more efficient market makers because they are based on smart contracts and are completely automated. The underlying protocol is similar to traditional market makers except that they are purely smart contract based. AMMs create markets by providing a price to the exchange which is based on a pricing algorithm that is coded as a smart contract to work in the blockchain.
AMMs rely on these smart contracts to be able to determine the price of a digital asset and concurrently interact with other smart contracts to make the market. AMMs make DeFi exchanges rely on their pricing algorithm instead of the traditional order book model. This process makes trading and exchanging digital assets faster and more efficient as it removes possible human errors as well. The reliance on smart contracts, however, may have its downsides as well if there are any bugs in the line of codes.
Characteristics of AMM protocols
Some key characteristics AMM protocols include the following:
AMM provides a single price for an exchange of two digital assets, not a full order book. Unlike a traditional order book where you can see different pricing levels with corresponding trading volumes, the AMM only has one price for the digital asset, and it is determined by the pricing algorithm.
AMM makes the price transparent as it is well known and deterministic. They make it consistently visible to all trading participants. This transparency helps create trust and confidence for investors. In some cases, they are called “trust-less” because there is no need for trust because everything is automated and based on smart contracts. There is no more trust factor to take into account because everything is transparent and automated.
The relationship between AMMs and liquidity pools
AMMs do not have the capital themselves. They rely on third-party participants to invest in their liquidity pools. Their source of capital for market making is through these liquidity pools which investors can participate in. Investors or capital providers of the liquidity pools are incentivized by getting a portion of the trading fees they earn from the exchange. AMMs share a part of trading fees as well.
In order to participate in the process of investing in AMMs, you must first lock your cryptocurrency pair (ex. ETH/USDT) in a liquidity pool. The amount of ETH must be equal to the amount of USDT you are locking into the liquidity pool. This lock-in period could take days, weeks, months, or even years depending on your preference. Generally, the longer lock-up period results in a higher token reward from the liquidity pool. However, you should take into account the risk of impermanent loss when participating in liquidity pools.
What is slippage tolerance?
One factor when trading in an exchange that you have to take into account is “Slippage”. “Slippage” occurs when a market participant settles for a different price than what they initially wanted. This slippage often results in lesser profits or even a loss for that trader. This is due to market illiquidity at the specific time they placed the order.
“Slippage tolerance” on the other hand, is the amount of slippage one is willing to accept. Most DeFi exchanges allow you to set a percentage of “slippage tolerance.” For example, for any trade, you can set it to 5% lower or 5% higher slippage tolerance. This means that for a particular trade, you are willing to take 5% higher/lower the initial amount you set the price in.
List popular Automated Market Makers (AMMs)
Built on the Ethereum blockchain, ERC-20 network which you can integrate with your digital wallets such as Metamask or Myetherwallet. It is an open-source platform where you can list your tokens and have control over them.
Another popular AMM is Balancer. It is also software running on Ethereum similar to Uniswap.
Curve Finance (CRV)
Curve is an AMM that boasts of lower exchange fees and lower slippage. However, this means that liquidity providers get lower fees as well for storing in this exchange.