Automated Market Makers, explained as simply as possible

DeFi

Automated market makers (AMMs) are an increasingly-popular branch of decentralized finance (DeFi), falling into the specific subset of decentralized exchanges (DEXs). AMMs’ broad goal is to reduce the number of moving parts that facilitate cryptocurrency trades by replacing limit orders (and the resources that go into fulfilling them) with an automated means of token price valuation. Sounds complicated, right? Well, it’s admittedly a concept that experienced crypto traders might grasp more easily than laymen. Put in simple terms, however, it’s not beyond your comprehension.

How Do Automated Market Makers Work?

To explain how AMMs work, we’ll first clear up a couple terms.

First, ERC-20 tokens. These are tokens designed specifically for use on Ethereum blockchains.

Next, liquidity pool. This term has been described as “levels at which price frequently ‘makes a decision’ as a large amount of orders hit the market”. You may think of a liquidity pool as the intersection between orders which ultimately determines where an asset is priced. Or, just think of it as the supply of a given asset, which determines the price of that asset.

Now, on to automated market makers. AMMs are platforms for trading cryptocurrency, generally built using the Ethereum blockchain and using a liquidity pool of ERC-20 tokens, as well as other coin types. The liquidity pool that funds AMMs takes the role of limit order books in other types of exchanges. Traditionally, an exchange host would have to process buyers’ and sellers’ orders to acquire or sell assets, then find a corresponding party that agrees to the terms of the limit order or sale. Not so with AMMs.

Rather, an algorithmic smart contract continually monitors the store of assets in the liquidity pool. As certain tradable assets are purchased in greater amounts, their supply declines and their price rises correspondingly. As an ERC-20 token in the liquidity pool is deposited back into the liquidity pool, its availability increases and its price therefore declines. The algorithm uses these relative supplies of certain tokens to determine their price in real-time. Rather than issue purchase orders or sale orders and arrange trading parties, the algorithm simply sets the price, and buyers and sellers are free to act based on that price range.

What Are the Benefits of AMMs?

The upside of automated market makers can be discussed relative to centralized markets as well as decentralized exchanges (DEXs). The primary advantage of AMMs over centralized alternatives is their decentralization. Rather than requiring human parties to match and process purchase orders (and possibly perform other administrative tasks required of a centralized exchange), smart contracts occupy the central role in AMMs.

Generally speaking, there are several benefits of decentralized governance. They include:

  • Fewer middlemen
  • Less opportunity for human grift
  • Fewer parties who justify their efforts by extracting value from the product (which oftentimes means the user)

Some “decentralized” forms of cryptocurrency exchange are only partially so, as they may have certain features of decentralization but ultimately have a centralized system of governance. For example, an exchange may outsource the processing of purchase and sale orders to humans in the name of expediency, or may have a centralized board of human directors. With AMMs, decentralization reigns to a significant degree (though the precise setup of each AMM must be evaluated individually). The very act of placing algorithmic smart contracts at the heart of pricing and order execution illustrates AMMs’ decentralized nature.

So what are the benefits of this decentralization, in real-world terms? They are:

  • Pricing, because it is determined mathematically, can be laid out in extensive detail (see Uniswap’s explanation on how it prices assets)
  • Total liquidity of an AMM can be fixed, which maintains a certain amount of price predictability for buyers and sellers
  • There is no need for third parties in between trading partners, as the contract handles the execution of trades
  • AMMs represent an efficient, streamlined means of trading cryptocurrency (at least in theory, as every AMM is different)

Another feature of AMMs is that those willing to provide liquidity to these markets may be able to do so, taking home some extra coin for their service.

How Do AMMs Benefit Liquidity Providers (LPs)?

You may understand by now that liquidity is critical to allowing AMMs to work. Without assets in the coffers, the entire operation falls apart—smart contracts cannot determine prices (which are based on the liquidity of specific assets) or fulfill trades if there are no assets to trade. So where does liquidity in these automated markets come from? In short, it comes from liquidity providers (LPs). Different types of AMMs may rely to varying degrees on liquidity providers, but they are important in every case.

Liquidity providers have a clear incentive to provide assets to the pool: fees, and possibly interest. LPs may generally receive a portion of trading fees in return for providing liquidity to the marketplace.

The crypto assets that LPs provide generally serve a couple of purposes:

  • To reduce the amount of “slippage”, or the difference between an algorithm’s projected price and the actual executed price of a trade, which may be due to drastic and sudden changes in supply
  • To provide liquidity for fulfilling trades

These LPs provide a crucial service to AMMs, and may generally make out well for doing so. However, there is risk in pledging their assets to markets, as negative changes in their tokens’ value due to market forces in a specific AMM may result in a phenomenon known as impermanent loss.

What Is the Future of AMMs?

Right now, the four big fish in AMMs are Uniswap, PancakeSwap, Sushi, and Bancor. These have proven to be viable means for trading cryptocurrency, and appear to be an integral part of the growing decentralized finance (DeFi) sector. There is clear appeal in AMMs. Namely, the ability to create a largely self-regulating market for cryptocurrency swaps has significant appeal for those who loathe middlemen.

There are also challenges. Attracting and maintaining the backing of liquidity providers is just one of those challenges. As trust in legacy financial systems continues to wane, the future of AMMs may become more clear. Will these automated markets become increasingly popular, and therefore sustainable, or will the challenges prove too great to achieve longevity?

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