One of the key promises of blockchain and cryptocurrencies is decentralisation. Even then, almost 99% of all cryptocurrency transactions took place through centralised exchanges in Q2 2019.
Not many traders prefer to trade on decentralised exchanges due to the lack of liquidity on these exchanges, which further only dries up DEXs.
As a solution, Bancor launched the first automated market maker, or AMM, in 2017 and Kyber Network followed suit. AMMs provided automated liquidity pools for decentralised exchanges.
What are automated market makers?
Automated market makers, or AMMs, are smart contracts that help in the operation of decentralised exchanges. Unlike traditional exchanges that rely on order books, there are no buy and sell orders in AMMs. Rather, the whole process is automated using the smart contract.
These smart contracts have liquidity pools that are either funded by a group of people who created the AMM or by users of the DEX itself. The Kyber Network AMM, for example, is funded by professional market makers while Uniswap, Balancer, and Curve are all open source.
These liquidity pools act as a store of cryptocurrency pairs. And anyone willing to exchange, more commonly called swap, their tokens for another cryptocurrency may easily do so from the available liquidity.
To know more about liquidity pools and why individuals prefer to fund these pools, please refer to our article on liquidity pools and yield farming.
Importance of AMM in DeFi
In traditional markets, exchanges rely on professional market makers who buy and sell assets from their own accounts in an attempt to make a profit and also add liquidity to an exchange.
That is, however, unlike what decentralised exchanges are supposed to be — automated and decentralised. Automated market makers ease the process of adding liquidity to decentralised exchanges without relying on central order books or centralised market makers. In doing so, they solve the biggest challenge of decentralised exchanges — liquidity, or rather the lack of it.
Additionally, they also make DEXs more democratic. Being permissionless protocols, AMMs do not require any personal information to set up accounts and start trading or providing liquidity. No central entity holds the authority to restrict any user or entity from using an AMM protocol.
Potential drawbacks of AMM
Human error is one of the most critical risks associated with AMMs. A bug in the code of the AMM may lead to hacks and thefts that may cost millions of dollars. On Sep. 29, $15 million were stolen from a new protocol that was still being developed by the founder of the famous DeFi protocol Yearn Finance.
“Impermanent loss” is another common drawback of AMMs. Although automated, AMMs need assistance from arbitrage traders, who correct the pricing of assets in the protocol. These traders make profits for their service that are paid from the liquidity pools. While liquidity providers earn trading fees, they may go in a loss if prices of the assets dip or rise to a great extent. The losses, however, are impermanent because the market can always correct, and the liquidity providers can earn back the lost amount.
DeFi is a growing space and AMMs along with projects that put them to right use have catalysed the growth of the space. They have certain drawbacks, the major one being the possibility of a bug in the code, but they’re well-positioned to take the decentralised world toward more adoption.