Automated Market Makers in DeFi and Why DeHive Won’t Use Them

Automated Market Makers are driving the industrial revolution in trading. Decentralized exchanges based on AMM are quickly spreading, but are they the future of trading? If not, what alternatives can you use to minimize the bottlenecks? Let’s find out.

What is AMM?

In simple words, Automated Market Makers (AMMs) are protocols that provide liquidity in specific markets through automated algorithmic trading. In the context of decentralized exchanges, AMMs formulas are implemented within smart contracts.

Decentralized exchanges mostly rely on smart contracts that create pools of token liquidity and set prices according to mathematical formulas. When users trade on such exchanges as Uniswap or Curve, they don’t interact with other traders; instead, they interact directly with the smart contract.

When a user makes a deal on an AMM-based decentralized exchange, the smart contract automatically sends tokens to the liquidity pool and then exchanges them for a similar token from the pair.

AMM pros and cons

Similar to any technology, AMM has some benefits and downsides that haven’t been improved yet. We’ll list the main pros and cons but focus more on the challenges that are yet to be overcome.

✅No KYC and no need to register an account

✅Easy to launch a new token on the market

✅No intermediaries

❌High risks of hacks and vulnerabilities

❌Money losses in case of impermanent loss

❌AMM stimulates gas price

Main challenges of AMM

Impermanent loss

Impermanent loss is the most common risk faced by liquidity providers at AMM. In essence, this is the drop in token value that users experience when they deposit tokens in AMM, compared to holding them in their wallets for the same amount of time.

An impermanent loss occurs when the market price between the tokens deposited with AMM diverges in either direction. As a rule, the greater the difference between the prices of tokens after their deposit, the more significant the volatile losses.

It is important to understand that AMM cannot automatically adjust token exchange rates. This means that arbitrageurs must buy undervalued assets or sell overpriced assets until the prices offered by AMM coincide with prices in foreign markets. The profits made by arbitrage traders come from the pockets of the liquidity providers.

Low Fund Utilization Rate

Another critical issue with AMM is the low fund utilization rate. The reason for that is in the algorithm in which liquidity is allocated. In simple words, you can effectively utilize only those funds that are allocated near the market price, but the rest stays idle. This leads to capital inefficiency and high slippage.

Additional Risk Exposure

The third bottleneck of AMM is the additional risk exposure that users have to take on as AMMs require the supply of two assets in an equal ratio. To understand this one better, just take a look at our example below.

Let’s say you have idle $50 in your wallet, and you want to earn some trading fees and deposit liquidity into Uniswap assets. In that case, you need to deposit another $50 worth of another asset, and now your holdings are impacted by the price fluctuations of the two assets. Not the most beneficial scenario, is it?

Read more about Automatic Market Making Models

Why DeHive Do Not Use AMM?

As you can see, AMM-based solutions are not stable and can’t guarantee the desired level of security. Moreover, users often face unpredictable losses that mess up the whole journey. That is why some projects designed alternative solutions that can significantly improve user experience.

DeHive is a decentralized protocol that allows wrapping your funds into the index representing the basket of top DeFi tokens. The protocol does not use AMM pools to generate the index or rebalance the prices of the underlying assets. Instead, DeHive uses oracles that monitor the actual prices and smart contracts that calculate the proportion of underlines.

DeHive index is driven by an economic model that creates an analogy of traditional stock market indexes based on the principle of market pairs. Thus, such a principle allows creating a user’s native crypto portfolio — similar to a traditional one. The absence of AMM in such a model makes the DeHive Index secure and authentic.

In addition, thanks to genuine portfolio formation, DeHive can be also seen as a tool for smart asset management. Thus with DeHive protocol, you get a bunch of tokenized assets securely stored and yield generating at the same time.

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The final word

Automated Market Makers are the driving force behind decentralized finance. They allow anyone to create markets and trade cryptocurrency in a decentralized and non-custodial manner. Still, there are some significant bottlenecks that make the user experience risky and challenging.

DeFi is still in its infancy, and its innovations are rapidly evolving. We believe that eventually, AMMs will improve their limitations and fix all the bottlenecks. Till that day, it is more secure to use AMM alternatives if you want to avoid any unpredictable losses.

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