What Is an Automated Market Maker (AMM)?
Automated market makers are an exciting new development in the decentralized finance industry. Let’s look at how they work and their current course.
An automated market maker (AMM) is a tool used to provide liquidity in decentralized finance (DeFi). They are used to enable the automatic trading of digital assets. They do this by using liquidity pools as a replacement for traditional buyer and seller markets.
You can think of an AMM as a program that helps traders swap between two assets at a fair market price.
AMMs quickly rose in popularity. Before AMMs, people had to use order books to trade. Traditional exchange platforms enabled people to offer different prices for buying and selling assets. After some time, other users select a listed price that they agree with. That price goes on to become the market price of the asset.
The traditional market-making process requires professional market makers who handle a lot of orders. So, they are expected to quote the volume they can trade along. They are limited in terms of the frequency with which they can quote the best prices. This requires sticking with a robust set of parameters during trading hours so they can quickly sell from their own inventory.
Most assets currently still rely on the traditional exchange structure. Securities and real estate are normally traded this way. AMMs offer a newer alternative that is applicable to DeFi.
How AMMs Work
An AMM is a DeFi technology that provides users with an option for trading at any time. Its first feature is that it rejects the traditional system for buying and selling. There are no gatekeepers, and you normally don’t even need to create an account.
AMMs are meant to provide liquidity to DeFi. Liquidity is the ability to convert one asset into another asset without changing its market price. Liquidity is naturally a challenge for DeFi exchanges, which contain new assets that are complex for many people.
AMMs solve these problems in a few ways.
AMMs provide traders with a new option by creating liquidity pools. They also incentivize liquidity providers to place more assets into the liquidity pool.
The more assets there are in a pool, the larger trades it can support. Users no longer need to just trade between buyers/sellers. What users do is trade against the liquidity pool.
The “pool” in “liquidity pool” is quite literal. When users contribute to a liquidity pool, they increase its liquidity, enabling traders to make larger swaps at the market price. A mathematical formula is used to price the tokens inside it.
In AMMs, the formula may be tweaked in various ways to optimize the pool for different purposes, to better facilitate swaps between different types of tokens.
Who Can Contribute to the Liquidity Pool?
Accessibility is another major feature of AMMs. If someone has an internet connection and any kind of ERC-20 token, they can contribute to a liquidity pool.
Why Do People Contribute?
Liquidity providers earn fees when traders interact with a pool. While this is the most common and direct way contributors are incentivized, there is another way liquidity providers can earn.
Some AMMs encourage liquidity provision by providing token rewards. With these AMMs, liquidity providers earn bonus yield through a practice called “yield farming”.
To participate in yield farming, users just need to add an appropriate balance of assets into a liquidity pool. After the contribution is confirmed, the AMM, true to its name, will automatically accrue reward tokens, which the liquidity provider can claim on a regular basis. The longer a liquidity provider contributes liquidity, the more reward tokens they earn.
The Future of AMMs
AMMs, first developed in 2018, are now a well-ingrained part of the DeFi ecosystem. Later versions have also added to the structure of AMMs, including automation tools for liquidity providers.
AMMs are about more than just providing greater liquidity between tokens. They are also about fostering a more secure and mainstream market. AMMs rely on smart contract technology to facilitate transactions more efficiently, which it has been successful at so far.
Going forward, AMMs have the potential to reach more investors. However, to get there, the innovation must ensure a high level of security and growth.
The DeFi space is already developing very quickly. AMMs are a fast-developing part of the development of the DeFi space and can be a core part of its progress.
While AMMs are already easy to use, there are a few that are pushing the technology further forward. They provide complex solutions that make it easy to trade and earn yield on your assets. The most generalized and usable example is Balancer.
Balancer Protocol is one of the leading AMMs, offering a self-balancing AMM and price sensor. The idea is to create the opposite structure of a traditional investment fund. Instead of paying fund managers to balance your portfolio, you collect fees from traders who rebalance it for you.
Balancer uses some clever maths to enable users to add a combination of up to 8 digital assets into a liquidity pool. Users can choose any custom percentage distribution for their combination of assets. That effectively means that users have a unique opportunity to create a self-balancing fund. Alternatively, users can just choose to invest in someone else’s.
Of all the AMMs, Balancer Protocol is the most generalized. While their solutions are complex, they provide simplicity and accessibility to all their customers. It’s not just an exchange, but a wider community.
The Bottom Line
Automated Market Makers follow up on the shortcomings of traditional market-making. The traditional process requires manual work which takes significantly longer for traders and market makers alike. The decentralized finance industry has been enabled to move much further ahead thanks to this new source of liquidity.
As DeFi continues to grow very quickly, AMMs will continue to play a key role in its development. Right now, only a few companies are providing new solutions within the AMM space. AMMs are a niche space within DeFi and have carved out their own territory due to their ease of use.