- Automated market makers have grown to become the backbone of the decentralized finance ecosystem and allow unrestricted access to cryptocurrency markets.
- AMMs use a pricing algorithm instead of order books to determine the price of an asset.
- AMMs allow practically anyone to launch a new market and/or provide liquidity for a token as a way to earn passive income in the form of exchange fees.
The decentralized finance (DeFi) sector of the cryptocurrency ecosystem was one of the driving forces that kicked off the bull run of 2021 as it offered a new way for crypto traders to acquire tokens for new or established projects without the need for centralized exchanges.
Automated market maker (AMM) protocols, such as Uniswap, played a large role in the growth of the ecosystem as a whole thanks to offering high liquidity, competitive trading volumes, and a steadily climbing number of users who are embracing the decentralized lifestyle.
Here’s a closer look at how AMMs work and a deeper dive into how they operate and why they are a fundamental part of the growing decentralized finance ecosystem.
What Is an Automated Market Maker?
An automated market maker (AMM) is a popular decentralized exchange (DEX) protocol that utilizes a pricing algorithm to determine the price of an asset instead of using an order book like traditional exchanges.
The algorithm used by each AMM varies from protocol to protocol and is largely dependent on the specific use cases targeted by each protocol. Uniswap, the most popular AMM DEX, uses x * y = k, where x and y represent the tokens in a liquidity pool and k is a fixed constant, which means that the pool’s total liquidity must always remain the same.
Although each mathematical formula used by each protocol may differ, they all share the same underlying function, which is to determine an asset's price algorithmically.
Essentially, AMMs decentralize the traditional market-making process and make it so that anyone can create a market on a blockchain and/or provide liquidity.
How Do AMMs Work?
AMMs work in a similar fashion as traditional order books in that there are trading pairs for traders or liquidity providers to choose from. The main difference is that with an AMM, a counterparty (opposing trader) is not needed to complete a trade. Instead, the system utilizes smart contracts to “make” markets that traders are able to trade at any time.
If typical exchanges are considered peer-to-peer (P2P) exchanges, AMMs can be thought of as peer-to-contract (P2C) exchanges. Due to the fact that there are no order books, AMMs have historically only offered market orders, but recent advancements in DEX technology have enabled traders to place other types of orders, such as limit orders, for certain token pairs.
Since there is no order book or market maker in the traditional sense, AMMs rely on liquidity providers (LP) to deposit liquidity into the smart contract for each pair on the exchange.
What Is a Liquidity Pool?
The smart contracts where liquidity providers deposit their funds are known as liquidity pools. This helps to create a large stash of funds that traders can trade against instead of market makers and order books. In return for providing liquidity, LPs earn fees from the trades that happen in their pool along with any other incentives that are offered by the DEX in question.
Due to the way that AMMs operate, attracting liquidity is important as having a larger amount of liquidity helps to reduce price slippage on large orders, which in turn can help to attract more volume to the platform. Since price is determined by an algorithm, the ratio of tokens in a liquidity pool can greatly affect the price paid if the ratio changes by a large margin in a short period of time.
Why Are AMMs Important?
Automated market makers have evolved to become the backbone of the DeFi ecosystem as they allow decentralized markets to function absent centralized order books and market makers.
On top of decentralizing the market-making process, AMMs also allow anyone with internet access to cryptocurrency markets without the need for KYC checks or self-identification.
While AMMs do have their limitations when compared to traditional exchanges and order books, their overall importance to the crypto ecosystem is invaluable and advancements in the technology are quickly helping AMMs compete with traditional exchanges like Coinbase and Binance.