What Is An Automated Market Maker (AMM)?

Defining AMM

AMMs, short for Automated Market Makers, allow Decentralized Exchange (DEX) users to get a price quote for the cryptos they want to trade. They interact with smart contracts most often on the Ethereum network so that you can trade on-chain with your own private wallet. AMMs are becoming increasingly recognized as a critical cog in the DeFi machine.

 

What Is A Traditional Market Maker?

You might be a bit confused about what a market maker even is. They’re pretty common, even in traditional finance. Market makers are firms or individuals that actively submit buy and sell orders in order to profit from the difference between bid and ask prices - known as bid-ask spread - and keep order books active in times of low trading volume.  

For example, a market maker might offer to buy 0.1 Bitcoin at $30K, and at the same time offer to sell the same token at a slight premium, say $30.1K. Market makers essentially ‘make’ the market for the token by tightening this bid-ask spread and filling order books.

Centralized exchanges (CEX) like Coinbase and Binance use order books and market makers to help make coin trading easier. They do this by keeping their order books full. 

An order book is essentially a list of buy and sell orders for a trading pair. There you can see each individual buy and sell order, including the bid or ask price and the desired price. Order books on crypto exchanges are usually organized by price level, with the current market price being the focal point. 

 

How Does An AMM Work?

Automated Market Makers might seem complicated since there are so many moving parts to a single transaction. These include liquidity providers, smart contracts, and a number of other technical things. 

In essence though, AMMs are just a type of software that helps a DEX price out a crypto that you’re looking to buy or sell without the need of an order book. It obtains that price with a series of mathematical formulae that are being calculated on a regular basis. Think of it as the code that makes your trades on a DEX happen, by interacting with project smart contracts so that you don’t have to. 

Important AMM Components

As mentioned before, AMMs require a few pretty complicated moving parts to function properly. We’ll try to break them down as simply as possible, and spare you the math. 

Liquidity And Liquidity Pools

If you’re not familiar with trading in traditional markets, you might not know what liquidity is. To put it simply, in traditional finance, such as with stocks, liquidity refers to how easily an asset can be converted into cash. For example, it’s pretty easy to turn one share or even 1000 shares of Disney into cash without any snags because of the deep liquidity in those markets.

At a crypto exchange, liquidity refers to how easily one crypto can be converted into another.

A core concept behind DEXs are liquidity pools. Think of liquidity pools as digital pools filled with two different cryptocurrencies. Instead of two people trading against one another, they trade against the pool created by liquidity providers. As the cryptos in the pool get traded in and out, the ratio of the two cryptos change, affecting their exchange price.

DEXs will often offer incentives to individuals or entities to deposit their funds into a liquidity pool (hence becoming liquidity providers). Earning platform fees and platform incentives by depositing one's funds is called Yield Farming. Anyone can become a liquidity provider and participate in yield farming.

Slippage

Ideally, exchanges want a lot of liquidity so that big trades do not make a significant impact on market price, known as slippage. With slippage, you receive fewer cryptos in a trade. That can be very frustrating in times of high trading volume! The more liquidity in a pool, the less slippage.

An AMM helps balance out those liquidity pools on a DEX to mitigate slippage, thereby creating a better trading experience for you. 

Impermanent Loss

Liquidity pools are great. As discussed, DEXs will often offer rewards for individuals who deposit their funds in a liquidity pool because of the good it does for the community and the platform. They are not without their problems, however.

Aside from protocol security concerns, impermanent loss (IL) is one of the main risks that a trader should consider when deciding whether to deposit funds in a liquidity pool. In short, impermanent loss is ‍the temporary loss of funds as a result of price volatility between assets in a liquidity pool and outside of it.

In layman’s terms, IL is the loss of funds that occurs when the price of a crypto in a liquidity pool moves significantly up or down. Using the ETH/USDC pool from above, if the price of ETH suddenly drops from $2k to $1500, the amount of USDC in the pool would need to drop in order to maintain pool balance. 

The reason it is called ‘impermanent’ loss is that you don’t realize the loss until you pull your assets.

*in-depth example

Let's assume that 1 X token is worth 100 Y tokens and you place them in a Uniswap pool at a 50:50 ratio (1 X and 100 Y tokens, with a net worth of 200 Y tokens). After your deposit, there are a total of 10 X and 1,000 Y tokens in the pool.

Now, if the price of X doubles (1 X is worth 200 Y now), arbitrage traders immediately get to work to balance the Uniswap pool. After a series of arbitrage transactions, the pool will have a different token balance; for example, something like 5 X and 1,000 Y tokens. Withdrawing your 10% liquidity returns 0.5X and 100Y tokens, which have a net worth of 200 Y tokens. 

If you had held on to your 1 X and 100 Y token portfolio, the net worth after the price movement would be 300 Y tokens: you suffered an impermanent loss worth 100 Y tokens. 

As a side note, there are now some DEXs with liquidity pools that have much lower IL risk by offering single-sided pools, like on DODO. A single-sided pool means you only deposit one crypto into a pool rather than both at the same time.

 

Where Are AMMs Used Today?

AMMs are essentially a DEX tool. Therefore, they are used to make DEXs function properly. You’ll find that every DEX uses an AMM in slightly different ways. 

Uniswap, The Dominant DEX On Ethereum

The reigning DEX champion is Uniswap. Although it was not the first to go all-in on AMMs, it is certainly the most popular and most-used DEX on the market today. Uniswap uses a simple A * B = C formula on its AMM, at least before V3 came out. A being one crypto and B being the other, C would be the total value of the liquidity pools.

The AMM then works to ensure balance in the pool and get the lowest price with the least amount of effort. At times of high price volatility or trading volume, the AMM struggles to do that but stays online. Such a problem, however, may arguably suit traders better than a complete shutdown of operations, which has happened at CEXs before.

At its April 2021 peak, Uniswap recorded an astounding $10 billion weekly trading volume. On May 5th 2021, it released its third version (V3) and decided to close its code - an unprecedented move in DeFi.

Uniswap’s biggest competitor on Ethereum is now Sushiswap. Sushiswap offers a wide array of other products designed to help traders make even more money. Also, Sushiswap is available on other mainnets like Polygon.

There are many more household names when it comes to DEXs and AMMs. Here are some names so that you can do some additional research: Quickswap, Bancor, Balancer, and Kyber.

 

Takeaways

Automated Market Makers can be considered as the engines that make DEXs work. They facilitate trades between users and project smart contracts, and they help determine a final settlement price for traders. As DeFi protocols gain popularity in the space, we will see AMMs become an essential part of the cryptocurrency industry.

Just to give you an idea of how important AMMs are, take a look at the tremendous growth of trading volume on DEXs since last year alone. In many cases, Uniswap surpassed even Coinbase in trading volume. 

If you aren’t trading on-chain yet, you should give it a try. These days, the trading experience has been simplified to mammoth extents, which traders even a year ago would have clamored for, were they available. And, as always, trade safely and responsibly!