Categories: Blockchain

Automated Market Makers: A Brief Guide

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.

Parting thoughts

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.

Recent Posts

How can Regulators Avoid Hindering Blockchain Innovation

Regulations are important for the advancement of technology in the right direction. But regulating new technologies has never been a…

4 weeks ago

Can Regulators Enforce New Laws on DeFi Platforms?

Regulating the flow of cryptocurrencies through centralised exchanges such as Coinbase and Binance was easy for regulators. They made sure…

1 month ago

What Makes Cryptlottery a Truly Fair Online Lottery Game

Bitcoin and crypto lotteries are all the hype in the online gambling industry these days. With rising global interest in…

1 month ago

Understanding the Ins and Outs of High Annual Percentage Yields in DeFi

Annual percentage yield (APY), unlike the annual percentage rate, is the rate of return one can earn on a deposit…

1 month ago

Understanding Yield Farming and Its Benefits and Risks

Decentralised finance has gained massive adoption within the blockchain and cryptocurrency community. The total funds locked in DeFi has scaled…

2 months ago

DEX vs. CEX: What You Need to Know

The cryptocurrency space has evolved beyond most people’s imagination. In the early days of cryptos, people would pay thousands of…

2 months ago