Automated Market Makers are decentralized exchanges where you can buy and sell with a smart contract but not other people. Also known as AMMs, they depend on mathematical equations to develop the value of a token.
Similar to regular exchanges, they comprise different trading pairs. A perfect example is an Ether (ETH) to Dai.
There are no trade orders, and traders don’t have to look for anybody to sell their coins. Alternatively, a smart contract is what will act as the maker in a trade. The idea is the same as quick-swap services like Changelly and ShapeShift. The dissimilarity is liquidity pools relace the company’s reserves depending on smart agreements.
A liquidity pool has two properties in a trading pair. Each token’s relative percentage in the pool determines the analytical price of a specific asset. Popular AMMs today include Kyber, Balancer, Curve, and Uniswap.
Why do Such Exchanges Exist?
This is because they make the process of providing liquidity cheaper and easier.
AMMs operate around the performance limits of smart contract blockchains like Ethereum. Before their rise, decentralized platforms set on Ethereum like Ox or EtherDelta tried to utilize a classical order book method.
This led to certain consequences because they faced challenges with liquidity because to place each order, you had to spend gas and await block confirmation times. ETH’s minimal throughput indicated that traders could only submit a minimal number of transactions before the blockchain’s flooding with such orders.
This was a challenge for most market makers who provide liquidity to book exchanges. ‘Creating’ a market needs regularly improving trade orders to the last charge, even when you don’t fill them. When each order you submit costs time and money, they can lose more than they achieve from the bid-ask spread. This is the disparity between the highest purchase price on offer and the minimal sell price.
Automated Market Makers make offering liquidity less expensive and easier through a fully automated instant process. That is the reason behind the name. Average users can also bid with their liquidity. Doing that on conventional trading platforms needs improved technical knowledge.
How Smart Contracts Make Trading Automatic on AMMs
This is possible via a mathematical formula that defines the cost of a specific token.
Users usually come into contact with the liquidity pool as they trade on AMM. A user instructs a smart contract to conduct trade under the pool before sending back their tokens like Ethereum to the liquidity pool. After that, a mathematical formula decides the number of tokens from the other part of the pair they should get in return.
The easiest formula is X × Y= K, where X and Y stand for the number of every token in the pool while K is an already defined constant. This equation is a true definition of a hyperbola: an easy mathematical shape that approaches zero and infinity but does not reach them.
Every trade has a slippage amount. This is how the order size affects the final cost in which you sell or purchase a token. The shape of the hyperbola indicates that there will be low slippage with minimal orders. With massive orders, slippage will rise rapidly. Uniswap utilizes this easy formula, but other trading platforms can utilize more complex math to adjust the slippage.
How to Use an Automated Market Maker
It’s as simple as connecting the wallet and confirming the transactions.
Users have to visit the website of the protocol before connecting a DeFi-enabled wallet to it. You can also use other front ends. After that, choose the asset you plan to trade before hitting swap and confirming the transaction on your wallet.
When it comes to providing liquidity, the procedure is the same as trading. Once you link your wallet, visit the liquidity provider part and choose the amount you wish to commit to a specific pool. In multiple protocols, you should have all types of assets present. A perfect example is when Ethereum is going for 400 Dai. You have to provide 1 Ethereum and 400 Dai simultaneously.
Once you confirm the transaction, you will get a token representing ownership in the liquidity pool. You can transfer this to anyone or redeem again for the remaining tokens and any fees that accumulate.
The Reason Behind the Popularity of AMMs
Automated Market Makers are becoming famous due to decentralization and lack of authorized use.
AMMs are solving the most significant challenge to the major approval of decentralized trading platforms: liquidity. Without the challenge, you can see the natural benefits of DEX. You can easily access AMM protocols with a lack of authorization, and you don’t have to create certain accounts or pass specific checks. You just need a wallet address to access the protocols.
AMM DEXs have easy-to-use interfaces because they don’t have to include advance order options or rate charts in one control panel.
What are the Limitations and Risks of AMMs?
The most common downsides of AMMs include bugs, impermanent loss, and improper pricing.
Vulnerabilities and hacks are the norms in exchange platforms like Balancer and Uniswap, where money was lost through complicated smart interactions. Liquidity providers can also lose money if the price hikes in a certain direction despite the trading fees. The cost is impermanent because the rate can always move in the opposite direction. However, this may not happen in practice.
Despite the different improvements, the liquidity volume of AMMs is still light compared to the biggest centralized exchange platforms. 2020 summer gas congestion was an indicator they are starting to hit their usage maximum, and improved scaling solutions must be implemented in the future.
Automated Market Makers, popularly referred to as AMMs, are decentralized exchanges where you can buy and sell with a smart contract but no other people. They depend on mathematical equations to come up with the value of a token.