TL;DR
You could think of an automated market maker as a robot thatโs always willing to quote you a price between two assets. Some use a simple formula like Uniswap, while Curve, Balancer and others use more complicated ones.
Not only can you trade trustlessly using an AMM, but you can also become the house by providing liquidity to a liquidity pool. This allows essentially anyone to become a market maker on an exchange and earn fees for providing liquidity.
AMMs have really carved out their niche in the DeFi space due to how simple and easy they are to use. Decentralizing market making this way is intrinsic to the vision of crypto.
Introduction
Decentralized Finance (DeFi) has seen an explosion of interest on Ethereum and other smart contract platforms like BNB Smart Chain. Yield farming has become a popular way of token distribution, tokenized BTC is growing on Ethereum, and flash loan volumes are booming.
Meanwhile, automated market maker protocols like Uniswap regularly see competitive volumes, high liquidity, and an increasing number of users.
But how do these exchanges work? Why is it so fast and easy to set up a market for the latest food coin? Can AMMs really compete with traditional order book exchanges? Letโs find out.
What is an automated market maker (AMM)?
An automated market maker (AMM) is a type of decentralized exchange (DEX) protocol that relies on a mathematical formula to price assets. Instead of using an order book like a traditional exchange, assets are priced according to a pricing algorithm.
This formula can vary with each protocol. For example, Uniswap uses x * y = k, where x is the amount of one token in the liquidity pool, and y is the amount of the other. In this formula, k is a fixed constant, meaning the poolโs total liquidity always has to remain the same. Other AMMs will use other formulas for the specific use cases they target. The similarity between all of them, however, is that they determine the prices algorithmically. If this is a bit confusing right now, donโt worry; hopefully, itโll all come together in the end.ย
Traditional market making usually works with firms with vast resources and complex strategies. Market makers help you get a good price and tight bid-ask spread on an order book exchange like Binance. Automated market makers decentralize this process and let essentially anyone create a market on a blockchain. How exactly can they do that? Letโs read on.
How does an automated market maker (AMM) work?
An AMM works similarly to an order book exchange in that there are trading pairs โ for example, ETH/DAI. However, you donโt need to have a counterparty (another trader) on the other side to make a trade. Instead, you interact with a smart contract that โmakesโ the market for you.
On a decentralized exchange like Binance DEX, trades happen directly between user wallets. If you sell BNB for BUSD on Binance DEX, thereโs someone else on the other side of the trade buying BNB with their BUSD. We can call this a peer-to-peer (P2P) transaction.ย
In contrast, you could think of AMMs as peer-to-contract (P2C). Thereโs no need for counterparties in the traditional sense, as trades happen between users and contracts. Since thereโs no order book, there are also no order types on an AMM. What price you get for an asset you want to buy or sell is determined by a formula instead. Although itโs worth noting that some future AMM designs may counteract this limitation.
So thereโs no need for counterparties, but someone still has to create the market, right? Correct. The liquidity in the smart contract still has to be provided by users called liquidity providers (LPs).
What is a liquidity pool?
Liquidity providers (LPs) add funds to liquidity pools. You could think of a liquidity pool as a big pile of funds that traders can trade against. In return for providing liquidity to the protocol, LPs earn fees from the trades that happen in their pool. In the case of Uniswap, LPs deposit an equivalent value of two tokens โ for example, 50% ETH and 50% DAI to the ETH/DAI pool.
Hang on, so anyone can become a market maker? Indeed! Itโs quite easy to add funds to a liquidity pool. The rewards are determined by the protocol. For example, Uniswap v2 charges traders 0.3% that goes directly to LPs. Other platforms or forks may charge less to attract more liquidity providers to their pool.
Why is attracting liquidity important? Due to the way AMMs work, the more liquidity there is in the pool, the less slippage large orders may incur. That, in turn, may attract more volume to the platform, and so on.
The slippage issues will vary with different AMM designs, but itโs definitely something to keep in mind. Remember, pricing is determined by an algorithm. In a simplified way, itโs determined by how much the ratio between the tokens in the liquidity pool changes after a trade. If the ratio changes by a wide margin, thereโs going to be a large amount of slippage.
To take this a bit further, letโs say you wanted to buy all the ETH in the ETH/DAI pool on Uniswap. Well, you couldnโt! Youโd have to pay an exponentially higher and higher premium for each additional ether, but still never could buy all of it from the pool. Why? Itโs because of the formula x * y = k. If either x or yย is zero, meaning there is zero ETH or DAI in the pool, the equation doesnโt make sense anymore.
But this isnโt the complete story about AMMs and liquidity pools. Youโll need to keep in mind something else when providing liquidity to AMMs โ impermanent loss.
What is impermanent loss?
Impermanent loss happens when the price ratio of deposited tokens changes after you deposited them in the pool. The larger the change is, the bigger the impermanent loss. This is why AMMs work best with token pairs that have a similar value, such as stablecoins or wrapped tokens. If the price ratio between the pair remains in a relatively small range, impermanent loss is also negligible.
On the other hand, if the ratio changes a lot, liquidity providers may be better off simply holding the tokens instead of adding funds to a pool. Even so, Uniswap pools like ETH/DAI that are quite exposed to impermanent loss have been profitable thanks to the trading fees they accrue.
With that said, impermanent loss isnโt a great way to name this phenomenon. โImpermanenceโ assumes that if the assets revert to the prices where they were originally deposited, the losses are mitigated. However, if you withdraw your funds at a different price ratio than when you deposited them, the losses are very much permanent. In some cases, the trading fees might mitigate the losses, but itโs still important to consider the risks.
Be careful when depositing funds into an AMM, and make sure you understand the implications of impermanent loss. If youโd like to get an advanced overview of impermanent loss, read Pintailโs article about it.
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Closing thoughts
Automated market makers are a staple of the DeFi space. They enable essentially anyone to create markets seamlessly and efficiently. While they do have their limitations compared to order book exchanges, the overall innovation they bring to crypto is invaluable.
AMMs are still in their infancy. The AMMs we know and use today like Uniswap, Curve, and PancakeSwap are elegant in design, but quite limited in features. There are likely many more innovative AMM designs coming in the future. This should lead to lower fees, less friction, and ultimately better liquidity for every DeFi user.