Five Essential Things You Should Know About Automated Market Makers

Automated market makers (AMMs) were first developed in 2018. Now, in 2021, “AMM-based exchanges are processing billions of dollars worth of on-chain transactions” daily. An AMM can be known as a program that helps automate the process of liquidation. AMM are part of decentralized exchanges (DEXs) where intermediaries are removed, and are also heavily involved in the DeFi environment.

5 essential points when it comes to understanding what AMMs are, and how it works.

#1 What are AMMs?

AMMs are automated market makers, commonly established in decentralized financial markets to eliminate or remove intermediaries between transactional parties. In a decentralized exchange, AMM comes into play with its autonomous trading mechanism, enabling unstoppable automated and decentralized trading using “algorithms to price assets in liquidity pools.” With AMMs, digital assets can be traded in a “permissionless and automatic way,” contrary to traditional markets with a buyer and seller. AMM executes trades on decentralized exchanges by using smart contracts and crowdsourced liquidity pools. 

#2 How do AMMs differ from traditional exchanges?

Traditional exchanges involve a market of buyers and sellers. In these exchanges, sellers can offer different prices for an asset (stocks, gold, real estate, etc.) to the buyer. When a buyer finds the price listed by the buyer acceptable, they may execute a trade. The price the asset is then traded as becomes the asset’s market price.

In decentralized exchanges with AMM, a single market price is declared through an algorithm. The pricing formula is “usually based on the pool’s current liquidity, or… the availability of a n asset in the pool.” In this case, AMM relies heavily on multiple liquidity providers to “ensure that tokens reflect a fair price.” 

#3 What role do AMMs play today?

AMMs play an essential role in the DeFi ecosystem, with decentralized exchange models. DEX users can enjoy the autonomy for initiating trades through non-custodial (full control) wallets. The difference between a custodial and non-custodial wallet is the level of control provided for the owner of the wallet. Find out more about non-custodial wallets in our blog on creating a wallet. In the DEX, AMM plays the role of deciding on the pricing of assets in the liquidity pool, through a protocol or an algorithm. Traders using the DEX can easily buy and sell crypto assets directly through the AMM. In order for an AMM to run optimally, liquidity providers must deposit their crypto assets to the protocol, creating a liquidity pool large enough to determine a fair price. The AMM would reward liquidity providers (the individuals who deposit their assets) with a fraction of the fees, usually distributed as LP tokens, generated on the AMM.

#4 Where are the AMMs being applied now?

AMMs in the DeFi ecosystem are being applied to Uniswap, Sushi, Balancer, and more. Uniswap is a decentralized liquidity protocol, where it uses smart contracts to connect liquidity providers with traders. Another popular application of AMM is seen in SushiSwap, a “decentralized exchange that processes token swaps and yield farming through an Automated Market Maker (AMM) smart contract.” SushiSwap also incentivizes liquidity providers by rewarding them with fees that other traders pay during token swaps. Balancer is also using AMM to offer a variety of tools for automated portfolio management, including, but not limited to “yield farming, gas-efficient token trading, and building custom DEX solutions.” Apart from trading cryptocurrencies or any ERC-20 token using AMMs, stablecoins can also be exchanged. Curve Finance, an AMM protocol, is a decentralized exchange built specifically for trading stablecoins on the Ethereum network.

#5 What is the future outlook for AMMs?

AMM is popular today due to the decentralized nature of liquidity pooling, where anyone can contribute to it and gain rewards, and also swap from it. AMM also removes any intermediaries seen in traditional exchanges, allowing traders to trade with lower transaction fees. In the DeFi space, AMM is highly adoptable from its quick and automated protocols, allowing it to run continuously in a decentralized environment. To find out more about DeFi and the future outlook of emerging technologies, you can read our blogs here. More applications of AMM protocol may appear in the future with establishing “stable liquidity levels and enabling price discovery in a range of different token pairs without any intermediaries” while more DEX would appear in the market to optimize trades and exchanges.

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***This article is not meant to offer any tax, investment or trading advice. The author of this article is not a licensed tax, investment or financial advisor***

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