BETTER THAN YESTERDAY WITH BSCSTATION #5: AMMs

When Uniswap launched in 2018, it became the first decentralized platform to successfully utilize an automated market maker (AMM) system.

An automated market maker (AMM) is the underlying protocol that powers all decentralized exchanges (DEXs); DEXs help users exchange cryptocurrencies by connecting users directly, without an intermediary. 

Simply put, automated market makers are autonomous trading mechanisms that eliminate the need for centralized exchanges and related market-making techniques. In this guide, we will help you explore how AMMs work.

What are AMMs?

Automated market makers (AMMs) allow digital assets to be traded without permission and automatically by using liquidity pools instead of a traditional market of buyers and sellers. On a traditional exchange platform, buyers and sellers offer up different prices for an asset. When other users find a listed price to be acceptable, they execute a trade and that price becomes the asset’s market price. Stocks, gold, real estate, and most other assets rely on this traditional market structure for trading. However, AMMs have a different approach to trading assets.

AMMs are a financial tool unique to decentralized finance (DeFi). This new technology is decentralized, always available for trading, and does not rely on the traditional interaction between buyers and sellers. This new method of exchanging assets embodies the ideals of Ethereum, crypto, and blockchain technology in general: no one entity controls the system, and anyone can build new solutions and participate.

How do Automatic Market Makers (AMMs) work?

AMMs have become a primary way to trade assets in the DeFi ecosystem, and it all began with a blog post about “on-chain market makers” by Ethereum founder Vitalik Buterin. The secret ingredient of AMMs is a simple mathematical formula that can take many forms. The most common one was proposed by Vitalik as:

tokenA_balance(p) * tokenB_balance(p) = k

and popularized by Uniswap as:

x * y = k

The constant, represented by “k” means there is a constant balance of assets that determines the price of tokens in a liquidity pool.

For example, if an AMM has ether (ETH) and bitcoin (BTC), two volatile assets, every time ETH is bought, the price of ETH goes up as there is less ETH in the pool than before the purchase. Conversely, the price of BTC goes down as there is 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. Only when new liquidity providers join in will the pool expand in size. Visually, the prices of tokens in an AMM pool follow a curve determined by the formula.

In this constant state of balance, buying one ETH brings the price of ETH up slightly along the curve, and selling one ETH brings the price of ETH down slightly along the curve. The opposite happens to the price of BTC in an ETH-BTC pool. It doesn’t matter how volatile the price gets, there will eventually be a return to a state of balance that reflects a relatively accurate market price. If the AMM price ventures too far from market prices on other exchanges, the model incentivizes traders to take advantage of the price differences between the AMM and outside crypto exchanges until it is balanced once again.

The constant formula is a unique component of AMMs — it determines how the different AMMs function.

Why is AMM important to investors?

AMM helps set up a system of liquidity where anyone can contribute to it. This removes any intermediary lowering transaction fees for investors. High liquidity is essential for healthy trading activity. If there is less liquidity, it could cause slippage. Low liquidity introduces high volatility in the prices of assets in the market.

AMMs also allows anyone to become a liquidity provider, which comes with incentives. Liquidity providers get a fraction of the fees paid on transactions executed on the pool.

The role of Liquidity Providers in AMMs

As discussed earlier, AMMs require liquidity to function properly. Pools that are not adequately funded are susceptible to slippages. To mitigate slippages, AMMs encourage users to deposit digital assets in liquidity pools so that other users can trade against these funds. As an incentive, the protocol rewards liquidity providers (LPs) with a fraction of the fees paid on transactions executed on the pool. In other words, if your deposit represents 1% of the liquidity locked in a pool, you will receive an LP token which represents 1% of the accrued transaction fees of that pool. When a liquidity provider wishes to exit from a pool, they redeem their LP token and receive their share of transaction fees.

In addition to this, AMMs issue governance tokens to LPs as well as traders. As its name implies, a governance token allows the holder to have voting rights on issues relating to the governance and development of the AMM protocol.

Yield farming opportunities on AMMs

Apart from the incentives highlighted above, LPs can also capitalize on yield farming opportunities that promise to increase their earnings. To enjoy this benefit, all you need to do is deposit the appropriate ratio of digital assets in a liquidity pool on an AMM protocol. Once the deposit has been confirmed, the AMM protocol will send you LP tokens. In some instances, you can then deposit – or “stake” – this token into a separate lending protocol and earn extra interest.

By doing this, you will have managed to maximize your earnings by capitalizing on the composability, or interoperability, of decentralized finance (DeFi) protocols. Note, however, that you will need to redeem the liquidity provider token to withdraw your funds from the initial liquidity pool.

What is impermanent loss?

One of the risks associated with liquidity pools is impermanent loss. This occurs when the price ratio of pooled assets fluctuates. An LP will automatically incur losses when the price ratio of the pooled asset deviates from the price at which he deposited funds. The higher the shift in price, the higher the loss incurred. Impermanent losses commonly affect pools that contain volatile digital assets.

However, this loss is impermanent because there is a probability that the price ratio will revert. Therefore, the loss only becomes permanent when the LP withdraws the said funds before the price ratio reverts. Also, note that the potential earnings from transaction fees and LP token staking can sometimes cover such losses.

Automated Market Maker Variations

The DeFi ecosystem evolves quickly, but three dominant AMM models have emerged: Uniswap, Curve, and Balancer.

• Uniswap’s pioneering technology allows users to create a liquidity pool with any pair of ERC-20 tokens with a 50/50 ratio and has become the most enduring AMM model on Ethereum. 

• Curve specializes in creating liquidity pools of similar assets such as stablecoins, and as a result, offers some of the lowest rates and most efficient trades in the industry while solving the problem of limited liquidity.

• Balancer stretches the limits of Uniswap by allowing users to create dynamic liquidity pools of up to eight different assets in any ratio, thus expanding AMMs’ flexibility.

Although Automated Market Makers harness a new technology, iterations of it have already proven an essential financial instrument in the fast-evolving DeFi ecosystem and a sign of a maturing industry.

Conclusion

Automated market makers are a staple of the DeFi space. They enable anyone essentially 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 are elegant in design but limited in features. However, there are likely more innovative AMM designs coming in the future. This should lead to lower fees, less friction, and better liquidity.

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About BSCStation

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Disclaimer: Cryptocurrency investment is subject to high market risk. BSCStation is not responsible for any of your trading losses. The statements made in this article are for educational purposes only and should not be considered financial advice or investment recommendation.