The Risks of Order Books and AMMs— What are Automated Market Makers?

When you’re trading, you buy a coin from an order book on an exchange. Do you know how an exchange’s order book affects you? Noticed how UniSwap’s order book is different from Binance’s, but do you know why? Automated Market Makers. You’re saying what now?

Hear me out.

On a Centralized Exchange (CEX):

• You can see the sellers’ asks and the buyers’ bids.
• You can make limit orders, requesting your specified amount at your desired price.
• You’re using a traditional order book.

On a Decentralized Exchange (DEX):

• You can’t.
• You can’t.
• You’re using an AMM.

On a CEX, you need a KYC, but you don’t truly control your wallet. On a DEX, you don’t need KYC, and you own the coins in your wallet.

An Automated Market Maker is what makes DEXs work. For they provide the money/liquidity rather than an institution.

Automated Market Maker

An AMM is a decentralized protocol that handles transactions by using liquidity pools and an algorithm to determine the price. It is the order book.

An example to help you understamd how they work:

Two farms decided to exchange produce based on an agreement that 1 fruit piece = $1. Each farm produces 5000. Total 25 million apples and oranges.

An AMM makes sure to maintain that ratio.

One day, a merchant wanted to exchange 700 apples for oranges.

5000 + 700 = 5700 apples.

An AMM then divides the 25m by 5700 to calculate the number of oranges left. 4385 oranges left. 615 oranges are exchanged for 700 apples

An AMM shows that apple’s price decreased to $0.87. Orange’s price increased to $1.14. Had the number of fruits in stock been higher, the price change would have been smaller. That’s why the higher the liquidity pool (the coins stock), the more stable the prices are.

About AMMs:

AMMs are transparent about the prices. They also communicate with other exchanges to keep a tap on the prices. Price differences between exchanges are common usually because a coin is traded more on an AMM than the other.

An AMM only holds the traded currency pairs but does not own the liquidity or the coins. But you said they provide liquidity?! Yes, they incentivize coin owners to provide their coins in exchange for trading fees proportional to the amount they’ve contributed.

They make money! They’re called Liquidity Providers (LPrs).

Liquidity Providers:

Liquidity providers get profits for the tokens they provide in liquidity pools. The smaller the pool, the higher the profits. Yet, there is a risk in supplying liquidity to small pools, temporary loss. The tokens can lose value due to price volatility and low supply.

That’s usually resolved by arbitrage trading. That occurs when people take advantage of the price difference between a pair and thus increase liquidity. But if you withdraw when the prices are skewed, you’ll face permanent loss.

(Hence the saying: “Don’t be someone’s exit liquidity.”)

Using an AMM:

To use an AMM, you must connect it to a wallet (like Metamask or Phantom).

Famous DEXs:

• UniSwap: deals only with ERC-20 pairs (Eth)
• PancakeSwap: first AMM on the Binance smart chain (BEP-20 pairs)
• QuickSwap: most popular AMM on polygon

Traditional order books on CEXs are suitable for those who aren’t actively monitoring market activity or trade frequently. They provide larger liquidity and a wide selection of pairs. They rule when it comes to the biggest mcaps: BTC & ETH. There’re advantages and disadvantages to each.

To take educated decisions, don’t forget to DYOR!

To find the crypto alpha, check out this article. And make sure to have a budget plan, read about it in this article.

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