Definition Of Automated Market Maker (AMM)

In this article, our main focus is on the definition of automated market maker (AMM). However, we shall also look into the meaning of liquidity pool, liquidity providers, formula for constant products, variations of automated market makers, impermanent loss, etc.

As the name implies, it is all about using automated trading to provide liquidity. It is provided to any exchange it operates in.

Meaning of an Automated Market Maker

Humans have already created order books before the invention of automated market maker. They manually initiate trades meant to enhance the liquidity of the market. In the early 1990s, Shearson Lehman Brothers and ATD implemented the AMM systems. This was before the take off occurred.

All the issues caused by human market makers were all resolved by the AMMs after their introduction. The had to introduce AMMs to decentralized exchanges. This are based on blockchain. The human manipulation on trades was the reason behind some slippage and latency in price discovery on the markets. However, the accusation of market manipulation was extended to market makers.

Users who also earn passive income, through trading fees provide liquidity. These fees depends  on the percentage of the liquidity pool provided. Liquidity pools that were initially funded for both assets of the trading pair replaced the traditional order book.The exchanges that operate on the basis of AMM.

Uniswap is an Ethereum-based decentralized exchange. It has implemented an AMM. It allows its users to exchange different assets. Users also supply liquidity in order to earn passive income.

Further Explanation on AMM

On a traditional exchange platform, buyers and sellers tags different prices for each asset. Once the listed price is acceptable, users execute a trade. The price at which that trade was performed becomes the asset’s market price. Here, liquidity pools replace a traditional market. Digital assets can also be traded without permission. The must not take permission from automated market makers.

AMMs approach trading assets in different ways. For instance, the traditional market structure is the pillar for stocks, real estate, and other assets.

There is a new method of exchanging assets. It covers the ideals of Ethereum, and blockchain technology in general. This means that anyone can build new solutions and participate in the exchange of assets. This way, one person doesn’t control the system. The financial tool unique to Ethereum and decentralized finance (DeFi) is AMM. This new technology is decentralized. This means that, it does not rely on the traditional interaction between buyers and sellers. It is always available for trading.

Meaning of Liquidity Pools; With Actuators of Liquidity.

It was not easy to find enough regular traders. There were few buyers and sellers because it is a new technology with a complicated interface. Liquidity means converting an asset (usually a fiat currency) into another asset without affecting it’s market price.

Liquidity was a challenge for decentralized exchanges. It became a problem before the existence of AMMs on Ethereum. AMMs creates liquidity pools, they also encourage LPs to supply assets. Increase in assets and liquidity in a pool also, increases the flow of trading on decentralized exchanges.

Actuators Of Liquidity

Users trade against a liquidity pool. The should rather trade amongst buyers and sellers. It takes place on AMM platform.

Users supply liquidity pools with tokens. The price of these tokens is determined by a mathematical formula. Liquidity pools can be modified for different purposes. This is when the formula is fine-tuned. We can say, a liquidity pool is a shared pot of tokens.

The only thing you need to provide liquidity is an internet connection. You can use any type of ERC-20 tokens. Just supply these tokens to an AMM’s liquidity pool and the job is done. You can earn a fee for providing tokens to the pool. Traders who interact with the liquidity pool are the ones that provide the fees. Do you know that liquidity providers through yield farming can earn yield ? This is in form of project tokens.

Formula of Constant Product

A simple mathematical formula is the little secret ingredient of AMMs. It can appear in various forms. The founder of Ethereum is Vitalik Buterin. Buterin posted about “on-chain market makers” one certain time. Since then, the primary way to trade assets in the DeFi ecosystem have been through AMMs. Vitalik’s equation :

tokenA_balance(p)* tokenB_balance(p) = k and popularized by Uniswap as:

x *y = k

The constant k means that, there is a constant balance of assets. This determines the price of tokens in a liquidity pool. For example, an AMM has ether (ETH) and bitcoin (BTC), two volatile assets. For each purchase of ETH , there is an increase in price of ETH. There were fewer ETH in the pool than before the purchase. However, in the price of BTC, the reverse is the case. It goes down because of more BTC in the pool. The pool stays in constant balance, where the total value of ETH in the pool will always equal the total value of BTC in the pool. The liquidity pool can’t expand until the introduction of new liquidity providers. A formula determines the prices of tokens in an AMM pool using a curve.

Judging with the state of balance being constant, buying one ETH slightly increases the price of ETH. Also, selling one ETH slightly decreases the price of ETH along the curve too. In an ETH-BTC pool, reverse is the case in terms of of BTC price. Volatility of the price doesn’t really matter, there will eventually be a return to a state of balance. Whenever the AMM price makes a shift , far from other exchanges, the model encourages traders to take advantage of the price differences.

The constant formula is a unique component of AMMs. It determines how the different AMMs operates.

Variations of Automated Market Makers

In Vitalik Buterin’s original post, he stated why AMMs should not be the only available option for decentralized trading. There should be many ways of trading tokens. Other exchanges were important in terms of keeping accurate AMM prices . However, he didn’t realize the development of various approaches to AMMs.

There are three dominant AMM models. They came to existence in the DeFi ecosystem. They are: Uniswap, Curve, and Balancer.

  • One of the first technology to emerge was the Uniswap. It allows users to create a liquidity pool with any pair of ERC-20 tokens with a 50/50 ratio. It has also become the most enduring AMM model on Ethereum network.
  • Curve specializes in creating liquidity pools of similar assets such as stable coins. To solve the problem of limited liquidity, it offers the most efficient trades in the industry. It also offers lowest rates atimes.
  • Balancer goes beyond the limits of Uniswap by granting users access to create liquidity pools of up to eight different assets that isn’t constant. It works with any ratio, thereby making AMMs flexible.

Automated Market Makers operates on a new technology. Its repeated performances have already proven an essential financial instrument in the DeFi ecosystem. It is also a sign of a progressive industry.

What is an automated market maker (AMM) all about

Instead of using an order book like a traditional exchange, a pricing algorithm is used to price assets. AMM is a type of DEX protocol that depends on a mathematical formula before assets are priced.

The formula can vary with protocols. For example, Uniswap uses x * y = k. In this formula, x is the amount of one token in the liquidity pool. While y is the amount of another token in the same pool. On the other side of the equation, k is a constant. Other AMMs can use other formulas depending on their target. However, the similarity between x, y and k is determination of the prices. This is through algorithm. I hope you understood the illustration made? still follow up.

Automated market makers allow any user to create a market on a blockchain. That’s what we call decentralization. Normally, traditional market making operates with firms with vast resources and complex strategies. On exchanges like Binance, market makers help you get a good price and tight bidask spread.

Operation of an automated market maker (AMM)

An automated market maker works similarly to an order book exchange. It works in terms of trading pairs like ETH/DAI. However, you don’t need a trading partner before trading is done. Rather, you interact with a smart contract. It “makes” the market for you.

On a decentralized exchange like Binance DEX, there is a system used to trade. It is known as peer-to-peer (P2P) transaction. You interact directly with your wallet. Let us say, you sell BNB for BUSD on Binance DEX,  another user buys BNB with their BUSD too.

Conversely, you could think of AMMs as peer-to-contract (P2C). There’s no need for looking for trading partners, it happens between users and contracts. There is no order book nor order types on automated market maker. A formula is rather used to determine the price you get for an asset. In the future, there is a probability that some automated market maker designs may go against this limitation.

Definition of a Liquidity Pool

You could imagine a liquidity pool as a huge rack of funds that traders can trade against. As a reward for providing liquidity to the protocol, Liquidty providers earn fees from the trades done in their pool. Liquidity providers add funds to liquidity pools. For Uniswap, LPs deposit an ratio of two tokens. Such as depositing 50% ETH and 50% DAI to the ETH/DAI pool.

It’s quite easy to add funds to a liquidity pool. It makes it possible for anyone to access it. The protocol will determine the reward.

The second version of Uniswap, charges a 0.3% trading fee. This goes directly to LPs. Sometimes, other platforms tend to charge lower transaction fees. This is their own strategy of attracting more liquidity providers to their pools.

With the way AMMs operate, it is very necessary to attract liquidity. Here is the reason, the larger the liquidity, the smaller the slippage encountered at large orders. This smaller slippage may seem to attract more volume to the platform, etc.

Use Of An Algorithm

As earlier discussed, an algorithm determines pricing. This algorithm represents, how much the ratio between the tokens , change with respect to each trade. The larger the ratio, the larger the slippage. Always consider slippage issues. It varies with different AMM designs.

Furthermore, there is a very high price attached in purchasing all the ETH in the ETH/DAI pool on Uniswap. This makes your action almost impossible. Let’s illustrate with the formula x * y = k. If either x or y is zero, meaning there is zero ETH or DAI in the pool, the result becomes zero too.

It doesn’t end here, we still have  to take a look at impermanent loss.

Meaning of Impermanent Loss

AMMs work best with token pairs that are similar in their values. Stable coins or wrapped tokens can serve as examples. Impermanent loss can be neglected if the price ratio of the token pairs are relatively small. Whenever the price ratio of deposited tokens changes impermanent loss is said to have taken place. The change is directly proportional to the impermanent loss.

Conversely, if the ratio change is much, liquidity providers should hold rather than staking their tokens. Despite that, Uniswap pools like ETH/DAI which are open to impermanent loss have been profitable. This is so because of the trading fees generated from them.

Therefore the name ‘impermanent loss’ isn’t the most suitable for this process. However, there are permanent losses if you request for withdrawal when the current price ratio is the same when you deposited. Sometimes, the trading fees might lessen the losses. But it’s still necessary to put the risks into consideration.

To avoid regrets, please understand the implications of impermanent loss first. Later you can deposit funds into an AMM.

Operation of Automatic Market Makers (AMMs)

There are 2 important things to know about AMMs.

  • Trading pairs on a centralized exchange exist as individual “liquidity pools” in AMMs. For example, if you wanted to trade ether for tether, an ETH/USDT liquidity pool is the only option for you.
  • Anyone can provide liquidity to the pools by depositing both assets represented in the pool. It is better than using dedicated market makers. For example, if you wanted to become a liquidity provider for an ETH/USDT pool, you’d need to deposit a certain advanced ratio of ETH and USDT.

AMMs use preset mathematical equations to balance the ratio of assets in liquidity pools. They use it to remove variations in the pricing. For example, Uniswap and many other DeFi exchange protocols use  x*y=k as an equation. It sets the mathematical relationship between the particular assets held in the liquidity pools.

Introduction Of Variables

Here, x denotes the value of Asset A, y signifies the value of Asset B, while k is a constant.

Illustrating the equation, Uniswap liquidity pools maintain a state. The multiplication of the price of Asset A and the price of B always equals the same number.

To understand how this works, let us use an ETH/USDT liquidity pool as example. When ETH is purchased by traders, they add USDT to the pool and remove ETH from it. This causes a decrease in the amount of ETH in the pool. Thereby, pushing the price of ETH to go up in order to fulfill the balancing effect of x*y=k. On the other hand, more USDT has been added to the pool, so the price of USDT falls. The process is vice versa when USDT is purchased. The curve below explains further.

Automated market maker equation

When a large amount of a token is removed or added to a pool, it can cause significant variations. This is between the asset’s price in the pool and its market price. Market price is the price it is trading at across multiple exchanges. For example, the market price of ETH might be $3,000 but in a pool, it might be $2,850. It is so because someone added a lot of ETH to a pool in exchange for another token.

This means ETH would be trading at a discount in the pool. Arbitrage opportunity is offered when this happens. Arbitrage trading is the strategy of finding differences between the price of an asset on multiple exchanges. It means buying an asset on the platform where it’s slightly cheaper and selling it on a higher platform.

Information On Arbitrage Traders

Arbitrage traders try to find assets that are trading at discounts in liquidity pools and buy them up. Then wait until the asset’s price aligns with its market price.

If the price of ETH in a liquidity pool is down, arbitrage traders use this opportunity to buy at lower rate, and sell higher. This is on other exchanges to make profit. For any trade made, the price of ETH staked tends to recover steadily until it matches the standard market rate.

Know that, the formula x*y=k is just one of the mathematical formulas in Uniswap. For instance, balancer makes use of a more complex form of mathematical formula. It combines up to 8 digital assets in a single liquidity pool. In contrast, a curve uses mathematical formula that pair stablecoins or similar assets.

Functions of Liquidity Providers in AMMs

To reduce severe slippages can be, AMMs incentivize users can deposit digital assets in liquidity pools. This will enable other users trade against these funds. The protocol rewards liquidity providers (LPs) with a percentage of the transaction fees carried out in the pool. This act instils encouragement. As discussed earlier, AMMs require liquidity to function properly. Pools with little funds are prone to slippages.

LP token and transaction fees are gotten when liquidity providers want to leave the pool. For example, if your deposit represents 1% of the liquidity locked in a pool, you will receive an LP token. It represents 1% of the transaction fees accumulated in that pool.

Furthermore, AMMs issue governance tokens to both liquidity providers and traders. A governance token gives voting rights to its holders. But it is based on issues relating to the governance and development of the AMM protocol.

Opportunities created by Yield Farming on AMMs

Yield farming has the benefit of increasing earnings for liquidity providers. Just deposit the correct ratio of digital assets. This protocol will send you LP tokens once your transaction is verified. Furthermore, you can proceed to deposit the tokens into a separate lending protocol. You will make your money!

Note that, before you can withdraw your funds from the initial liquidity pool, you will need to redeem the liquidity provider token. It helps in maximizing profits by capitalizing on the interoperability of DeFi protocols.

Meaning of Impermanent loss.

We must have come across the word impermanent loss. It refers to one of the risks associated with liquidity pools. Impermanent loss takes place when there is fluctuation in the price ratio of pooled assets. There are pools that contains digital assets which are volatile. A liquidity provider deposits funds at a particular price. Whenever there is deviation in the price ratio of the pooled assets, losses are made. The shift in price is directly proportional to the loss incurred.

Price ratios usually reverts. But  when funds are withdrawn before the reversal, permanent losses are made. However, those losses are often taken care of by the potential earnings from transaction fees. It is also by liquidity pool token stake. Impermanent loss is gotten from funds. This is after reversal of price ratio.

CONCLUSION

With what we have discussed, I believe you now know the definition of automated market maker (AMM). Now, you can comfortably say the meaning of liquidity pool, liquidity providers, formula for constant products, variations of automated market makers, impermanent loss, etc.

See the List of things to learn.
  1. Blockchain Technology
  2. Defi
  3. NFTs
  4. DAOs
  5. Crypto
  6. Web 3.0
  7. Altcoin Tokenomics
  8. Metaverse
  9. Smart Contracts

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