Automated Market Maker
An Automated Market Maker (AMM) is a decentralized asset trading pool that enables market participants to buy or sell cryptocurrencies. AMMs are non-custodial and permissionless in nature. Most AMMs utilize either a constant product, constant mean, or constant sum market-making formula; however, the most common is a constant product market maker, most notably Uniswap.
Automated market makers are smart contracts that create a liquidity pool of ERC20 tokens, which are automatically traded by an algorithm rather than an order book. This effectively replaces a traditional limit order book with a system where assets can be automatically swapped against the pool’s latest price.
There are two main types of automated market makers (AMMs). While one may be governed and set up by professional market makers, the other is fully automated by a set algorithm, allowing any user in the market to participate by depositing liquidity into the smart contract.
How Automated Market Makers Work
Automated Market Makers (AMMs) work similarly to an order book exchange in that there are trading pairs. For example, ETH/DAI. However, users don’t need to have a counterparty (another trader) on the other side to make a trade. Instead, they interact with a smart contract that makes the market for them.
Users are able to trade trustlessly using an AMM and 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.
In early 2018, the Kyber Network was one of the first AMMs to introduce automated liquidity pools to the crypto ecosystem.
Kyber Network’s liquidity pools are deployed by either professional market makers or by the project’s team. The pools are not open for anyone to provide liquidity.
The price of the tokens in the liquidity pool can be set by external oracles or automatically determined by the smart contract parameters during setup. Both of these setups allow for market makers to have greater control of the pool in times of high volatility.
Uniswap was the first true decentralized AMM to enter the market in November 2019. It was developed by Hayden Adams after reading a Reddit post from Vitalik Buterin. The protocol allows for anyone to deploy a liquidity pool on the network, and enables any other trader in the ecosystem to contribute liquidity.
The price in the Uniswap smart contract cannot be configured or controlled. The price of the tokens in the pool is fully determined by the balance ratio between the two tokens in the pool.
Curve Finance has admin-only generated liquidity pools where everyone can contribute to these pools. Curve’s liquidity pools only support stablecoins.
Curve’s decision to focus on only stablecoins is a feature and not a limitation. By offering stablecoin only liquidity pools, the exchange is able to complete large trades with low slippage due to its concentration of deposits in its limited amount of pools.
Uses of AMMs
Automated market makers serve dual purposes. For traders, AMMs allow for an instant trade experience bought at market price; for liquidity providers, market participants can earn trading fees from each trade.
Professional market makers might be more comfortable with a system like Kyber Network, while regular crypto users are becoming more comfortable with Uniswap and Balancer. Users that are looking for steady interest rates on their stablecoin holdings can use Curve.
In either case, it is advised for users of AMMs to monitor their pools and verify that market conditions are in their favor. Inexperienced users can quickly learn that impermanent loss can end up taking away all of the profits that they’ve accumulated from trading fees.
In November 2020, PredIQt launched MindSwap an AMM on the EOS blockchain. MindSwap brings liquidity pools to PredIQt by allowing anyone to easily wrap the PredIQt market shares they’ve bought into tradable EOS tokens. These PredIQt tokens are then deposited into liquidity pools along with an equal amount of another asset like the IQ token. From there they’ll earn a 0.7% transaction fee anytime someone uses the pool to trade between IQ and the PredIQt tokens.
This can all be done in a few minutes through the MindSwap user interface. Liquidity Providers (LPs) can withdraw their tokens from the pool at any time and convert their PredIQt tokens back into PredIQt shares. One issue that MindSwap solves better than existing AMMs is impermanent loss of divergent assets like prediction market shares. Typically, assets that tend toward 1 or 0 in price have high degrees of impermanent loss due to the natural movement of the share token against the trading token.
MindSwap smoothes out this issue with a higher fee to liquidity providers. This is why the current 0.7% fee is used as compared to the standard.6%. As the team building MindSwap implements more sophisticated bonding curves and AMM features, MindSwap will be able to tackle impermanent loss in a more efficient way and lower fees to encourage more traders.
- List of DeFi terms
- Liquidity Mining
- Whale (cryptocurrency term)
Automated Market Maker