What is an Automated Market Maker (AMM)?

Automated Market Makers (AMM) have been a crucial concept for the success of Decentralized Finance (DeFi), or at the very least, some of its biggest aspects. Without them, decentralized exchanges (DEXes) would not be able to function, and users were unable to benefit from them. That all changed in 2018, when Uniswap launched, becoming the first decentralized platform to successfully use an AMM system.

What are Automated Market Makers (AMM)?

Simply put, an automated market maker (AMM) is a protocol that allows decentralized exchanges to run. DEXes allow users to exchange digital currencies with one another by connecting them more directly, without intermediaries, and AMM function as autonomous trading mechanisms that allow it to happen.

Thanks to them, the DeFi sector can function without the need for centralized exchanges or other market-making techniques.

But, in order to truly understand how big of a contribution AMM made in helping develop decentralized finance, we should go even deeper and explain what market makers themselves are.

What Are Market Makers and Why Do They Matter?

Before the DeFi sector exploded in 2020, decentralized exchanges were not seeing too much use. In fact, even though Uniswap came up with an AMM system in 2018, many were wondering whether DEXes will ever take root, or if they will just disappear as another failed experiment of the crypto sector.

The reason for this is that they lacked liquidity. Liquidity is extremely important for trading, whether in crypto or traditional finance because it means that users can complete their trades quickly, make use of the beneficial price changes, or cut their losses and save what they can if the price suddenly starts crashing.

Without it, no one would risk trading on the platforms, which is what happened with old DEXes. They lacked liquidity because nobody would use them, and nobody would use them because they lacked liquidity. With the crypto industry being extremely volatile, rapid price changes could happen at any time, and users need to be able to react quickly, with no time to wait and waste in waiting for someone to come to the platform with the intention of purchasing the exact amount of coins that the seller is offering, or vice versa.

This issue was solved on centralized platforms by market makers — protocols that facilitate the process required to provide liquidity for the listed trading pairs. Of course, in that situation, the centralized exchange (CEX) oversees the entire process, as well as the operations of traders, and it provides a system that makes sure that all trading orders are matched accordingly.

So, if one trader wishes to buy a certain amount of a specific coin, CEXes match them to a seller which sells that coin and offers the approximate amount, with a similar price. In other words, CEXes act as middlemen between the traders.

This system has worked well enough for years, and the process has grown to become quite seamless. With increased adoption, it became easier to match buyers and sellers and help them conclude their deals. But, there are not always such perfect opportunities available, and sellers with certain needs don’t often immediately find buyers with the matching needs.

If the exchange cannot find a good match, the liquidity is considered to be low. In other words, liquidity is the ease of buying and selling assets at a certain time. If there are plenty of buying and selling orders available, matching them is a simple matter, and the liquidity is considered high.

In these cases, we tend to see slippage, which is the situation when the price of an asset at the point of executing the sale is different than it was before the trade was completed. Basically, exchanges will ensure that the trade is conducted, but if there are no trades that deal with the same price, they will find the next best thing, which would be an offer with a significantly lower/higher price.

This is especially the case during highly volatile periods, where immediate transaction execution is imperative. However, slippage is extremely bad for traders, which is why exchanges are doing everything in their power to ensure that traders never have to experience it. The way they do it is by relying on financial institutions and professional traders to provide liquidity for the needed trading pairs. These entities are asked to create a number of orders that will match the requests of the exchange’s users, thus ensuring that there is always enough liquidity to match the demand.

How Is an AMM Different?

The way market makers work is fine for centralized platforms, but decentralized exchanges wish to be more independent, which is why they found a different approach. They do not use order-matching systems like the CEXes, nor do they have a custodial infrastructure, meaning that they hold neither the private keys of traders’ wallets nor the funds stored within. They are truly decentralized, meaning that traders are the only ones with access to their money.

As for the order-matching systems, they were replaced with AMMs — protocols that rely on smart contracts. Smart contracts are used to define the asset’s price based on supply and demand, and they also provide liquidity. But, how did they solve the issue of low liquidity?

Simple — they created liquidity pools, which are essentially smart contracts with large quantities of coins and tokens stored within. These funds are stored by retail users themselves, who are therefore named liquidity providers. Essentially, the platforms provide an incentive for users to store their dormant coins and tokens into a smart contract and make them available to the exchange’s other users.

In return, they receive rewards that come in the form of passive income. Furthermore, AMM also use preset mathematical equations in order to ensure that liquidity pools will remain as balanced as possible. This also eliminates any discrepancies when it comes to the pricing of the pooled assets.

Of course, users are not required to deposit their assets, and they are free to withdraw them at any time. Some platforms may include penalties if users withdraw their funds before the predetermined period runs out, but that is not the case on every platform, and if it is one of the conditions — it is clearly indicated in the contract.

It is also worth noting that numerous platforms also issue special governance tokens, which are another form of incentive. With governance tokens in their possession, users are granted the ability to participate in the governance of the entire project. They get the right to propose changes that would benefit the platform and its community, or to vote to proposals published by other users. In these situations, the vote of users that own more governance tokens typically carries more weight than those who have fewer of them in their possession. If the majority of governance token holders vote that the proposal should be implemented, the developers will make it happen.

The Risks of Liquidity Pools

One last thing to explain is one of the biggest risks that are associated with liquidity pools. This is something called impermanent loss, and it happens when the price ratio of pooled assets fluctuates.

In these situations, the liquidity pool will automatically incur losses when and if the pooled assets’ price ratio changes from the price that the assets had when they were deposited in the smart contract. Obviously, the higher the price change is, the higher the losses that the user ends up suffering.

Impermanent loss is the most common when it comes to the pools that contain highly-volatile cryptocurrencies. However, it is also important to note why the loss is called “impermanent.” The reason for this is the fact that there is a chance that the price ratio will revert, and that the price will return to the height it had when it was deposited.

This can, once again, happen due to the high volatility of digital currencies, some more than others. In other words, if the price of the stored assets changes while the assets are stored, users are facing a potential loss. That loss does not have to happen, and the only way to solidify it is to withdraw the assets from the liquidity pool before the price reverts to the original (or higher) price.

Another thing worth noting is that the losses can also be covered by the rewards that the user received while keeping their tokens locked up. So, while withdrawing the tokens at that point would mean that the reward is forfeit, at least the user would not suffer a loss, but would instead find themselves in the same situation (when it comes to the value itself) as when they stored the tokens in the first place.

Conclusion

Automated Market Makers (AMM) are an essential part of the decentralized finance sector, or more specifically, of decentralized exchanges. Because of them, decentralized exchanges are capable of providing their services without having to rely on the methods used by their centralized counterparts, and all DEXes are now using them as the most efficient way to offer liquidity to the cryptocurrency industry.