A Brief Introduction to Automated Market Makers (AMM)
Automated Market Makers are that seem to be in their infant stage with many limitations but still bring invaluable innovations in the crypto market.
Let us, deep-dive, into the concept of "Automated Market Maker (AMM) ".
What Is an Automated Market Maker?
Automated Market Maker is a mechanism that executes the trading of digital assets without any permission and trade executes automatically with the use of liquidity pools that replaces buyers and sellers.
It is a type of decentralized exchange (DEX) protocol that relies on the mathematical formula to set the price for the assets. This formula is the replacement of order books in traditional exchanges where the price of the assets is determined by pricing algorithms.
The Formula can vary for each of the Protocols. For Example, in the DeFi Protocol, Uniswap uses x*y = K, where the term x denotes the amount of one token and y represents the amount of other tokens in the liquidity pool.
This Automated Market Makers (AMM) is a part of the Decentralized Finance (DeFi) Ecosystem and plays a significant role in improvising the DeFi Space.
Before the arrival of Automated Market Making
Before the arrival of Automated Market Makers, the Cryptocurrency Exchange Globe was ruled by "Order Books". The Order book is nothing but a mechanism that lists all the buy and sell orders which replicate the price and quantity of the crypto assets.
The matching of buyer and seller orders eats some valuable time of the traders and also has some major issues such as slippage and latency in the price discovery & more.
The major issue of the Order Book mechanism is the news that highlighted in the newspaper about Market Makers like Nasdaq and NYSE, which created an unsafe environment for human market makers.
Early Stages of Automated Market Making
The first financial organization that utilizes automated market-making was Shearson Lehman and Brothers. This technology was simple and it is to reduce the chances of any human errors and bring high liquidity to the market.
This automated market maker algorithm works according to " if this then that", this means that it takes an action if the price of an asset moves up or down. Since Automated Market Maker is quite complicated, this involves the math formula to calculate the price of the assets.
Since, this Automated Market Maker technology benefits most of the traders and companies, since one should pay a commission fee if there is winning or losing.
How Does Automated Market Maker Work?
An Automated Market Maker works like order books in any exchanges that are trading pairs. But you don't need to have a counterparty on the other side to finish your trade. Instead, you will be interacting with smart contracts, which automate the trade and makes a market for you.
On many decentralized exchanges, the Automated Maker Model is preferred for trading cryptocurrencies.
In Binance DEX, the trading happens directly between user wallets which do not involve any need of buyer or seller.
For Example: When you sell BNB for BUSD in Binance DEX, there are some others on the other side to buy BNB using BUSD. This implies P2P or Peer Peer transactions on the Binance DEX.
In contracts, one may think of AMM as Peer to Contract (P2C). Since there is no need for counterparties which implies the trade occurs between users and contracts.
There are no order books in the AMM mechanism, there are no order types in this technology.
Since in AMM, there is no need for counterparties, but still, there should be someone to create a market, isn't it?
Still, the liquidity in smart contracts has to be provided by traders who are known as Liquidity Providers (LPs).
The liquidity providers add assets as funds to the liquidity pools. AMM benefits many DeFi protocols which have their own liquidity pools allowing their users to act as liquidity providers and add funds.
Get Detailed Insights about DeFi Liquidity Pools!
Benefits of Automated Market Maker
Automated Market Makers has been changing the space of cryptocurrency trading. The benefits that cryptocurrency exchanges experience by utilizing the automated market-making mechanism.
- Many new trading models are created by using this automation mechanism.
- Due to this market develops high liquidity
- Latency on trades can be measured in milliseconds instead of seconds.
- Reduces the ability of front running, wash trading, price manipulation, and more.
- Price Slippage is counted less than a penny, between the trade executions.
- It takes only a fraction of seconds to create and set costs for orders.
- This system made everyone happy as it reduces the price fluctuations and gains new acceptable profit margins.
These are the benefits of Automated Market Making in the Cryptocurrency Exchanges.
AMMs in DeFi Space
As said above, the Automated Market Makers are the best part of the decentralized finance (DeFi) globe. The liquidity pools and liquidity providers play an important role in the Automated Market Maker model built DeFi protocols. The first AMM that went live on the Ethereum Blockchain was Bancor (BNT). The AMMs provides liquidity in any of the two ways:
- Either by a centralized group of professional market makers
- Fully Automated process defined by algorithms.
The first choice requires eligibility requirements to participate as liquidity providers when the second choice is open for any party to join the liquidity pools. Thus there are many DeFi protocols in the world that act as Automated Market Makers.
Kyber Network comes under the first category whereas Balancer, curve comes under the second category.
Best Automated Market Makers in DeFi World
Listed here are the top DeFi Protocols, which act as the best Automated Market Makers in the cryptocurrency globe.
Uniswap is a decentralized open-source protocol that is being the first Decentralized AMM launched in November 2018, which provides instant, automated liquidity without relying on any order book.
This protocol leverages the liquidity providers who deposit ERC 20 tokens into the pools for support trading. To make the market stable, Uniswap relies on the mathematical equation which defines the ratios of the tokens that are held in the pool.
Curve an open-source DeFi Protocols launched in January 2020, aims to provide liquidity by functioning as a Decentralized Exchange (DEX) for the stable coins.
This can be used by both individuals and smart contracts and these curve protocols have a featured native governance token called CRV.
Balancer defines itself as an open-source AMM which allows any users to earn any income just by leveraging their own cryptocurrency assets holdings.
Balancer distinguishes itself from the rest of the pack and it supports the customization of the ratios, trading fees and thus allowing LPs to make their funds.
Kyber Network is the earliest AMMs to enter into the market in Feb 2018, Kyber Networks liquidity pools are not open to anyone.
Kyber Network describes itself as a blockchain-based liquidity protocol that aggregates liquidity and it is designed in a way that allows market makers to have complete control of the pools.
Look at the table to get information about the DeFi Protocols mentioned above.
Future Of Automated Market Makers
This concept of Automated Market Makers has been perfected slowly over years and the recent push to decentralized governance through the tokens pushing it for the new level of interest in the field of decentralized finance.
As of now, there are many DeFi based AMMs providing higher liquidity and helping users to yield high when adding assets to liquidity pools.
Many AMMs in the DeFi space are kicking off the use of a middleman, order books, and more for executing any cryptocurrency trading.
Thus, with AMM the decentralized finance ecosystem is making a better way to trade, swap, and exchange tokens instantly without any inconvenience.
We Bitdeal - Leading DeFi Development Company, leverage the use of Automated Market Making mechanism in our cryptocurrency exchange script development to launch cryptocurrency exchange with greater liquidity and also leverage the use of DeFi open-source protocols to develop DeFi based AMM exchanges with liquidity pools.
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