Understanding how market makers work and how liquidity is generated helps users make more profitable swaps and discover new opportunities in DeFi.
Traditional market exchange processes involving stocks, precious metals and other assets are based on buying and selling orders, providing various prices and building an order book on the exchange. A user makes a trade when they agree to a list price set by a seller. These processes always require a counterparty – a trading pair – to complete a trade.
Automated Market Makers (AMMs) are protocols that support DEXes and offer a decentralized automated approach to crypto asset exchanges. The key difference is that there is no need for another trader to perform a swap as the protocol provides the market for users and settles the other side of a trading pair. A user interacts with a smart contract and not with another seller or buyer.
AMMs: key DEXes liquidity providers and a passive income opportunity
The term “automated market maker” refers to an asset price that is automatically determined by an algorithm that calculates token shares in a liquidity pool. A required trading pair is taken from liquidity pools – storage of cryptocurrencies on the balance of a smart contract. They are provided by platform users who provide assets to receive rewards in return. LP tokens (liquidity provider tokens) represent the share of users in the pool. When a trade is made on a DEX, the transaction fee is shared between all pool members. The liquidity provider’s rewards consist of proceeds from transaction fees.
A user’s passive income depends on their share of the total liquidity volume: the higher the LP amount, the higher the reward.
Pools can be formed from two or more equivalent tokens. For example, if a user adds liquidity to a pool of tokens A and B and A is worth $0.5 and B is worth $1, the user must deposit 100 A tokens and 50 B tokens.
As mentioned above, the assets within the pool are managed by an algorithm that sets digital asset prices. This algorithm allows for permissionless and automatic trading of tokens instead of a traditional buyer-seller market. Liquidity pools provide an opportunity to generate stable passive income, but they carry the risk of temporary loss. This happens when the price of assets added to a liquidity pool changes between deposit and withdrawal, resulting in a loss for the liquidity providers.
AMMs provide ways to avoid temporary losses. The core idea is to manipulate their curvature distributions and optimize the token price. Some protocols use a native token, others don’t. Ephemeral losses can be avoided, for example, by using transaction fees that cover the difference in value of blocked and withdrawn funds, or by additionally minting native tokens if the transaction fees do not fully compensate for the ephemeral loss. Platforms allow pooled assets to be locked on different terms: some allow liquidity to be provided within a certain price range, while others do away with the dual-asset model and offer multi-token pools.
Slippage is another risk users can face in a liquidity pool. Slippage occurs when a price quoted by a DEX changes between the time of the quote and the time of the swap. When a token pair has low liquidity, collective market moves are required to cause changes in the pool price. DEXes offer users the ability to control slippage by setting limits.
Overall, AMMs provide users with various earning opportunities such as; B. Earning interest while providing liquidity and arbitrage (when trading at a discount compared to an unbalanced pool).
Thus, AMMs play a crucial role in the development of the market where anyone can contribute to add the liquidity and profit from it. The larger the liquidity pools, the easier it is to execute swaps and the healthier the trading activity in the market. As long as users are willing to act as liquidity providers, AMMs can provide more liquidity than traditional market makers, facilitating trading between cryptocurrencies at a reasonable market price. They also lower transaction fees by eliminating middlemen.
The role of PMM on DEXes
The acronym PMM can be found in different interpretations. On 1inch, it stands for “Private Market Maker” and refers to companies that execute buy and sell orders through the 1inch API, thereby generating additional trading volume.
Another use case for acronyms can also stand for Proactive Market Maker when referring to the DoDo DEX protocol and copying the behavior of AMMs and human traders.
PMMs (Private Market Makers), which typically work with CEXes, can also trade on DEXes with low risk and offer RFQ capabilities that allow users to set orders for a specific cryptocurrency.
At 1 inch the process is as follows:
When an order is placed, the limit order protocol asks the PMMs if they are willing to exchange. Signing an order for a significant amount can be beneficial for the PMMs as they can resell these assets on another platform for a profit.
“Off-chain” transactions using PMMs can be conducted in OTC (over-the-counter) mode. Here you will find detailed information on how they work.
Aggregated AMM and PMM liquidity
While AMMs are important DeFi drivers, they sometimes require more liquidity for certain transactions, and PMMs can be useful when large amounts of liquidity are required. The 1inch Aggregation Protocol addresses potential liquidity issues by cross-checking different DEXes. It finds the best swap price by aggregating information from hundreds of platforms and automatically selecting the cheapest options.
The backbone of this protocol is the Pathfinder algorithm. It ensures an optimal swap strategy by offering the best trading routes across multiple markets, while also taking gas fees into account. It is connected to both AMMs and PMMs, making it easy to scan the prices of all existing sources of liquidity for every swap that users make. The number of liquidity sources currently exceeds 250. In addition, there are the most widespread networks to choose from: Ethereum, BNB Chain, Avalanche, Polygon, Optimistic Ethereum (oΞ), Gnosis, Fantom, Arbitrum, Aurora and Klaytn. This allows users to save on gas fees and choose more appropriate transaction terms.
The Pathfinder algorithm also ensures the minimal price impact of a swap. Similar to slippage, the price effect refers to rapid price changes that depend on the liquidity of the asset. High liquidity usually guarantees low price impact. The difference from slippage is that the price impact is caused by the user’s trading and not by market movements.
Splitting the swap across different liquidity sources guarantees the lowest price impact.
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