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What is an Automated Market Maker? A Guide for Beginners

Automated market makers (AMMs) have become the backbone of decentralized trading, enabling a seamless crypto asset trading experience that everyone can enjoy.

Posted September 19, 2023 at 7:30 am EST.

Automated market makers (AMMs) make it easier for decentralized exchanges to provide liquidity in a secure and decentralized manner. Read on to learn what automated market makers are, how they work, and the different types of AMMs you can use.

What is an Automated Market Maker (AMM)?

An Automated Market Maker (AMM) is a protocol that facilitates decentralized trading through the use of smart contracts and liquidity pools that replace the order book of the centralized crypto exchange. They are the brainchild of the co-founder of Ethereum Vitalik Buterin.

AMMs allow crypto traders to trade with each other without the need for a central authority to maintain an order book to match buyers and sellers. Instead, Use AMMs mathematical formulas to price digital assets based on liquidity pool balances, while also offering liquidity providers (LPs) a share of trading fees as an incentive to provide liquidity to a trading pool.

How does an automated market maker work?

An AMM is a smart contract responsible for adjusting the prices of trading pairs in a liquidity pool depending on their current supply and demand on the decentralized trading platform.

Since there is no order book, the smart contract is programmed with a specific formula that determines the price for an asset based on trading activity within the pool. Traders trade with the smart contract and not directly with another trader. This is possible thanks to the liquidity contained in the smart contract.

This is how it generally works.

  • A trader deposits (usually two) assets into a liquidity pool via a decentralized read protocol.
  • The AMM uses an algorithmic pricing formula to ensure there is enough liquidity to process trades.
  • Traders can exchange one crypto asset for another within seconds by trading directly with the liquidity pool.
  • Asset ratios in the liquidity pool adjust as more trading occurs, especially during volatile market movements, ensuring that prices continue to move in line with supply and demand.
  • Liquidity providers receive fees for each transaction in proportion to the amount of liquidity they provide in the pool.

In cases where the price ratio of assets changes after the liquidity provider deposits them into a pool, there is a phenomenon called temporary loss. The size of the impermanent loss increases with the size of the changes. Since price conditions change dramatically, there is little incentive for liquidity providers to add their assets to the pool. Trading fees are designed to reduce the risk of temporary losses.

Types of Automated Market Makers

Now let’s take a look at the different types of AMMs you’ll find in the DeFi landscape.

  • Constant Product Market Maker (CPMM): The first AMM, the decentralized exchange Bancor, popularized the Constant Product Market Maker, which uses the function x*y=k, where k is a fixed constant and x and y are the amounts of the liquidity pool assets. With the equation, the available liquidity determines the price range for the two crypto assets. An example of a platform that uses this model is Uniswap.
  • Constant Sum Market Maker (CSMM): While CSMMs are ideal for zero-price impact trades, they do not offer unlimited liquidity. They use the x+y=k formula, which allows liquidity providers to withdraw their assets if the off-chain price between the assets in the pair is not 1:1.
  • Constant Mean Market Maker (CMMM): According to this model, the pool can contain more than two cryptocurrencies. The formula for a liquidity pool of three crypto assets is (x*y*z) = k.
  • Hybrid CFMMs: They combine multiple functions to achieve specific results. The advanced AMMs aim to address issues of temporary losses and low capital efficiency. An example is Curves AMM, which combines both CPMM and CSMM to minimize impact on price and improve efficiency in capital utilization.
  • Proactive Market Maker (PMM): The model mimics the market making behavior of a traditional central limit order book. The price curve of each asset moves proactively in response to market changes. An example of a platform that uses this model is DODO.
  • Dynamic Automated Market Maker (DAMM): This model integrates several dynamic variables into its algorithm to ensure adaptability to changing market conditions. During periods of low volatility, liquidity is concentrated near the market price to increase capital efficiency. In contrast, during periods of high volatility, liquidity is distributed to ensure traders do not suffer temporary losses. One platform that uses this model is Sigmadex.
  • Virtual Automated Market Makers (vAMM): The model uses the same formula as CPMMs. However, traders deposit collateral for a smart contract and do not rely on a liquidity pool. Perpetual Protocol uses this model.

Advantages and disadvantages of automated market makers

Like any other innovation in the DeFi ecosystem, AMMs have their advantages and disadvantages. Let’s take a look at them.

Advantages

  • The trading process is more efficient because there is no intermediary.
  • Easy access for anyone with an internet connection and a crypto wallet.
  • Users can earn fees as liquidity providers.
  • Minimal system costs result in lower trading fees.

Disadvantages

  • Price fluctuations and temporary losses can result in significant losses.
  • Intelligent, contract-based automation makes AMMs vulnerable to potential exploitation by hackers.
  • AMMs do not have access to all markets like centralized exchanges do.
  • Often offer less liquidity than centralized exchanges, especially for smaller trading pairs.
  • The complexity may exclude users with limited technical knowledge.
  • High gas fees can reduce returns.

Summary

AMMs are extremely attractive due to the democratization and simplification of the trading process on decentralized exchanges. With more time and innovation, AMMs will inevitably evolve to improve the trading experience in global crypto markets.

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