What Is an Automated Market Maker (AMM)?
An Automated Market Maker (AMM) is an algorithm to facilitate decentralized exchange trading.
AMMs are designed to provide traders with access to liquidity and enable them to trade tokens without needing order books or market makers.
They work by automatically setting prices for buyers and sellers based on supply and demand, thereby minimizing spreads, reducing transaction fees, and improving overall efficiency in the process.
An AMM can operate 24/7 with minimal human intervention by using smart contracts.
This makes it ideal for high-volume trades that require quick execution times and low slippage rates.
With increasing crypto assets traded on decentralized exchanges today, AMMs have become popular among many traders looking for reliable liquidity solutions.
Overview of Automated Market Maker (AMM)
Are you looking to dip your toes into the world of cryptocurrency and curious about the term, "automated market maker"? Let’s break it down a bit.
An automated market maker, or AMM, is a type of decentralized exchange that uses mathematical formulas to calculate the price of a digital asset. Essentially, instead of relying on buyers and sellers to make trades and set a price, the AMM uses an algorithm to determine the value based on supply and demand.
AMMs are popular because they’re efficient, have low fees, and can offer users liquidity. While the concept may seem intimidating initially, you'll quickly see its benefits once you dive in and start using an AMM.
These days, almost every decentralized exchange is an AMM. Because of this, the terms DEX and AMM are sometimes used interchangeably.
And if AMMs are almost completely synonymous with dexes, is there ever a scenario when an exchange is not using an AMM to power trades? Yes. Some use the old-school order book method.
What Is an Orderbook? And Why Don't AMMs Need Them?
Order books are a critical component of conventional exchanges that, in simple terms, track the supply and demand for orders. As buyers place bids and sellers place asks at different price points, it creates an order book with the different prices available.
On the other hand, AMMs don't need order books to operate because they use algorithms to calculate prices based on supply and demand.
By utilizing smart contracts to adjust prices automatically, the AMM can quickly facilitate trades with minimal human intervention required. This makes it ideal for high-volume transactions that require quick execution times as well as low slippage rates.
Benefits of Using an AMM
There are many benefits to utilizing an Automated Market Maker (AMM) over traditional exchanges. As mentioned previously, AMMs provide traders with access to liquidity and enable them to trade tokens without the need for order books or market makers.
Additionally, they can operate 24/7 with minimal human intervention required, making them ideal for high-volume trades that require quick execution times as well as low slippage rates.
Furthermore, AMMs can reduce transaction fees and minimize spreads by automatically setting prices for buyers and sellers based on supply and demand.
Finally, because most of their operations are automated, traders don't have to worry about liquidity or price manipulation from market makers. This is critical in helping to ensure fair and transparent trading for all users.
But what about the passive income guys? Not everyone wants to be a crypto trader.
AMMs offer opportunities for most people in the space. To make a trade, there needs to be liquidity. For there to be liquidity, the AMM needs to host liquidity pools on their site. In this scenario, users provide liquidity, essentially becoming the bank.
They are rewarded with emissions of the AMM’s token and, depending on the specific AMM model, will also be rewarded with a cut of the fees from trades going through their invested pools.
What’s in It for the Protocols?
Protocols want their tokens whitelisted on decentralized exchanges. Not only do they want them listed, but they want deep liquidity. This phrase, “deep liquidity”, is something you’ll see repeatedly in the space.
But what’s the point, and why do they want it?
There are a few reasons. First, when users see a token whitelisted on a reputable exchange, they assume it’s trustworthy and not some type of scam. They’re more willing to buy, sell, and hold the token.
Secondly, without deep liquidity, tokens can become illiquid. No one wants a token they can’t get rid of at their convenience. Low liquidity can also result in high slippage, which is what occurs when the price a trader thinks they get is substantially different from what they actually receive on a trade.
And lastly, when dexes and projects are willing to incentivize pools to get this deep liquidity, it can be incredibly lucrative for the people participating in the pools in the form of rewards. And if people are holding a token and using it to provide liquidity, they aren’t selling.
How Does an AMM Work?
An Automated Market Maker (AMM) automatically sets prices for buyers and sellers based on supply and demand. AMMs utilize smart contracts to adjust their prices in real-time, so traders can benefit from the best available price.
Furthermore, using algorithms allows them to identify market trends and respond accordingly quickly.
For example, if a particular token's price is increasing rapidly, the AMM will adjust its prices accordingly to provide liquidity and minimize slippage. In this way, traders can take advantage of more favorable prices while ensuring adequate liquidity levels.
Increasing Popularity of AMMs for Trading Cryptocurrencies
The popularity of Automated Market Makers (AMMs) has been steadily increasing as more traders look for reliable liquidity solutions – thanks to their 24/7 operations, low fees, and ability to quickly adjust prices efficiently.
With the popularity of Uniswap, most dexes forked the code, and AMMs took the defi world by storm. Balancer eventually released their own tech, and now Solidly forks are becoming a popular AMM. They’re all offering their own unique take on AMMs, and the competition has resulted in more rewards for liquidity providers and better fees for traders.
Using smart contracts also helps minimize spreads, making them ideal for large-scale trading operations.
Factors to Consider When Choosing an AMM Exchange
Several factors must be considered when choosing an Automated Market Maker (AMM) exchange. First and foremost, traders should look for exchanges that offer competitive fees and minimal slippage rates.
Furthermore, they should ensure the AMM is reliable and secure by researching user reviews or testing its features.
These days, most traders use a dex aggregator for their trading needs. These websites scour all of the dexes on the blockchain and give you either the cheapest fee or the highest return, depending on your selection. Popular aggregators in Defi include 1inch and Firebird.
Even if you use aggregators for all of your trades, it’s still a good idea to familiarize yourself with the different types of dexes and what they offer. Newer dexes may have many incentives, so they’ll get deep liquidity quickly. But it might not last long if a lot of mercenary capital is on the table.
Older dexes may have deep liquidity, but up-and-comers might offer better deals. Traders need to stay current on everything that’s going on, as slippage and fees can eat into profits.
Uniswap is one of the most popular Automated Market Maker (AMM) exchanges available, offering traders access to liquidity and competitive fees. Uniswap currently uses its V3 model, which uses a concept called concentrated liquidity. It allows more advanced mechanics to enable traders to get the best deals and liquidity providers to get the most reward.
The license recently ended. Most Uniswap forks have either released their own version or are currently working on innovation to this tech to make it even better.
Another popular Automated Market Maker exchange is Balancer. It’s a powerful technology. Balancer is on several chains, with a friendly hard fork called Beethoven X on a couple of chains as well. Unlike other forks, the original team works with the forked team and collaborates often.
One specific thing that Balancer does that no other AMM can provide is “weighted pools” These are more similar to index funds than the traditional Uniswap 50-50 pools. So if you want to invest in a pool that’s 25% ETH, 25% BTC, 25% USDC, and 25% FRAX, Balancer is going to be the best protocol for you.
Solidly was the brainchild of one of the most respected figures in Defi, Andre Cronje. It’s similar to Uniswap in that it utilizes 50-50 pools. However, liquidity providers do not receive trading fees.
Instead, this model uses curve’s ve(3,3) locking mechanic to keep people from dumping the farm token and incentivizes users to lock the token for additional rewards.
Holders of these locked tokens vote weekly to direct emissions for the following week. Voters receive extra rewards, including trading fees and bribes from protocols that want deep liquidity on the dex.
Some of these Solidly forks already offer their own versions of concentrated liquidity and play around with fascinating new technology while using Andre’s vision as a strong base.
By utilizing smart contracts to automatically adjust prices, these types of exchanges can provide users with access to liquidity and minimize trading costs.
With their increasing popularity in the cryptocurrency industry, it's clear that AMMs have become an essential tool for many traders.
However, it's important to carefully consider all factors before committing to an AMM exchange to ensure that the best possible service is being used.
By doing so, traders can be confident that they are making informed decisions and getting the most out of their trading experience.