Cryptonomics: Automated Market Makers (AMM)

AMMs are the backbone of trading on DeFi platforms, and every crypto investor should understand how they function.

By
Wilfred Victor
on
June 11, 2021
Category:
Cryptonomics

Cryptonomics: Automated Market Makers

Decentralized Exchanges (DEXes) have continued to expand, and Automated Market Makers (AMMs) have been the primary technology adopted due to its ease of use and proven decentralized system.

Exchanges

Exchanges have been utilized since the inception of cryptocurrencies to facilitate transactions. Exchanges play a role similar to modern-day brokers, matching buyers, and sellers using order books. These are fundamental aspects of markets as they provide services necessary to facilitate transactions.

Traditional exchanges are centralized, meaning a central party owns the exchange and facilitates all transactions on top of holding custody over users’ tokens. As of the recent decentralization boom, the decentralized exchange has taken the scene by storm. DEXes are transforming the crypto space as we know it, capitalizing on centralized exchanges' weaknesses.


Introduction

You could think of an AMM as the mechanics behind the decentralized finance industry; it’s a typical type of algorithm that is integrated in most DEXes such as Uniswap, Raydium, and Serum. This technology allows users to receive price quotes between two assets in real-time in both a decentralized and permission less manner. While all AMMs use the same basic concepts, the application varies across DEX engines from the simple calculation process of Uniswap to much more complicated machines like Serum and Raydium.


What is an AMM?

AMMs changed the way we interact with coin swaps; they allow for easy exchange across different types of coins in a non-custodial, peer-to-smart contract manner. These exchanges are fully decentralized and are executed using liquidity pools, algorithms, and arbitrage (game theory). AMMs highlights the trustless nature of trading in a decentralized engine; AMMs also enable users to make the market by providing liquidity to the protocols liquidity pools. Users who offer liquidity to make the market are incentivized to do so through liquidity and fee incentive structures. The largest AMM is Uniswap, an Ethereum based DEX platform, and they allocate 0.3% of trading fees collected to liquidity providers (LP); the payments are distributed based on the proportion of users holdings.

In contrast, Solana-based AMM platforms like Raydium reward LPs around 0.22% in trading fees. On top of this fee allocation, users are rewarded in native token RAY rewards for providing liquidity. Raydium is also deflationary in nature, as they have a 555 million hardcap for RAY. They burn RAY acquired from fees to maintain the deflationary nature of the token. The emission schedule of RAY will also be halved every six months to slow inflation.

Overall, AMMs revolutionize the traditional market maker set up, which relies on human interaction, working with a firm with vast resources, and complex strategies to ensure a tight bid-ask spread. AMM technology automates the whole process, enabling user interaction directly with a smart contract.


How Does An AMM Work?

Unlike centralized platforms, there are no order books available on AMM protocols; users interact with an integrated smart contract and user liquidity provision. Prices are determined algorithmically following an already established formula for price determination by the DEX protocol. This algorithm leverages game theory, relying on arbitragers to equalize the assets price over all mediums of exchange.


What Is A Liquidity Pool?

Trades executed on DEX AMMs are made possible by user liquidity provision, allowing users to provide to a liquidity pool. This “pool” caries out real-time decentralized swaps using the LP’s large reserve of funds. In return for their provisions, LPs are typically rewarded with a certain percentage of trade fees collected from that pair.

In traditional AMM protocols, LPs provide an equivalent amount of 2 assets, for example, 50% SOL 50% RAY, to become a liquidity provider of the selected pair.

Adding Liquidity On Raydium

The process is as simple as connecting a wallet address and then adding liquidity. Users can then collect rewards in RAY for staking the LP.

Liquidity Provision Risks: Impermanent loss

Liquidity providers in AMMs suffer what is referred to as “Impermanent Loss” (IL) due to the arbitrage that AMM technology relies on. To keep prices in line with other exchanges users will arbitrage across exchanges with motives of profiting. These users keep the price in equilibrium, but the LPs are on the other side of the arbitrage, selling or buying to arbitragers at a premium.

For those who wish to learn more about the risk of impermanent loss, check out our article here.


AMM Weaknesses

Due to no centralized entities making the market, AMM DEXes can struggle to maintain ample liquidity for specific token pairs. Typically, CEXes have very deep liquidity allowing buyers and sellers to agree on prices easier, keeping the spread tight. Due to AMMs niche nature that relies on liquidity providers to create market depth, specific low-demand token pairs may not be offered or may trade at premiums. AMM DEXes combat this by providing liquidity incentives, but the issue is still prevalent in specific scenarios.

IconDescription automatically generated


Summary

The cryptocurrency market is an ever-evolving marketplace that has brought many novel innovations in the last decade. DEXes have continued to expand, and AMMs have been the primary technology adopted due to its ease of use and proven system. The wave of AMMs solves many gripes that come with CEXes, regarding token custody, Know Your Customer (KYC), and decentralization. These exact reasons are why users continue to adopt these exchange methods, allowing users to efficiently swap tokens while introducing innovative financial products such as “liquidity mining.”

While AMMs often lack strength in having substantial liquidity and centralized organization, they introduce a novel solution to traditional CEXes issues. Overall the DEX AMM boom has just begun, and these models will see increased innovation as time continues to press on.

Tags:
No items found.
Wilfred Victor

Ace finds himself as a blockchain enthusiast who is focused on growing with the entire crypto sector. He is an energetic and passionate writer who believes that all things are achievable.