For ease of understanding, you can imagine an automated market maker as a robot that is always ready to automatically price between two assets for you. Some use simple formula to calculate like . While , Balancer and other platforms use more complex formulas.

With , you can trade trustless and can also act as an exchange by providing liquidity to a liquidity pool. This basically allows anyone to become a market maker on the exchange and earn a fee for providing liquidity.

AMM has really created their niche in the space with its simplicity and ease of use. The decentralization of the market in this way is inherently based on the nature and vision of .

Introduce

Decentralized Finance (DeFi) witnessed an explosion of  and smart contract platforms (Smart contract) other like  . Yield mining has become a popular way to distribute tokens,  tokenized in development on and fast loan volume is growing rapidly.

Meanwhile, automated market-making protocols like  regularly witnessing high trading volumes, high liquidity and increasing number of users. So, how do these exchanges work? Why setting the market on platforms with “food” like Pancakeswap so quick and easy? Can AMMs Really Compete with Traditional Exchanges? Let's find out together.

What is an Automated Market Maker (AMM)?

Automated Market Maker (AMM) is a type of decentralized exchange protocol () is based on a mathematical formula for valuing assets. Instead of using an order book like a traditional exchange, assets are priced according to a pricing algorithm. This formula may vary from protocol to protocol.

For example, Uniswap uses the formula x * y = k. Inside, x is the number of tokens in the liquidity pool and y is the amount of the other token. In this formula, k is a fixed constant. This means that the pool's total liquidity must always remain the same.

Other AMMs will use different formulas for specific use cases, depending on their goals. However, the similarity between all these tools is that they all determine the price algorithmically. If this is a bit confusing, don't worry; You will be answered from now until the end of the article. 

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Traditional market-making is often suitable for companies with vast resources and complex strategies. The market maker helps you get a good price and tight bid-ask spreads on an order book exchange like  .

Automated market makers decentralize this process and essentially allow anyone to make a market on the internet. . How can they do that? Find out more.

How does an Automated Market Maker (AMM) work?

AMM works similar to an order book exchange, in that there are trading pairs - for example: / DAI. However, you do not need to have a counterparty (another trader) on the other side to make a trade. Instead, you interact with a smart contract that "creates" the market for you.

On a decentralized exchange like  , transactions take place directly between user wallets. If you sell to get BUSD on Binance DEX, there will be someone else on the other side of the purchase in their BUSD. We can call this a peer-to-peer (P2P) transaction. 

On the contrary, you can consider AMM as transaction person-to-contract (peer-to-contract or P2C) . There is literally no counterparty, as the transaction takes place between the user and the contract. Since there is no order book, there is no order type on the AMM either.

Instead, the price you get for an asset you want to buy or sell is determined by a formula. It should be noted, though, that some future AMM designs may counteract this limitation.

So there is no need for a partner, but someone has to create the market right? Exactly. Liquidity in smart contracts must still be provided by users, called liquidity providers (LPs).

What is a liquidity pool?

Liquidity Pool

Liquidity providers (LPs) deposit into a liquidity pool. You can imagine a liquidity pool as a large pile of money that traders can trade for. In return for providing liquidity to the protocol, LPs earn fees from transactions that occur in their pool. With Uniswap, LPs send the equivalent of two tokens – for example, 50% and 50% DAI into the group / DAI.

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So, anyone can be a market maker? Right! It is quite easy to add money to the liquidity fund. The reward will be determined by the protocol.

For example, Uniswap v2 charges traders 0.3% and goes directly to liquidity providers. Other platforms or forks may charge lower fees to attract more liquidity providers to their pools. Why is attracting liquidity important?

Because of the way AMM works, the more liquidity there is in the pool, the larger orders can be less slippage. That could attract even more volume to the platform.

Slippage issues will vary with different AMM designs, but this is definitely something to keep in mind. Remember, token prices are determined by an algorithm. Simply put, the price is determined by how the ratio between the tokens in the liquidity pool changes after the transaction.

If the rate changes by a wide range, there will be a large amount of slippage. To understand better, let's take an example. Let's say you want to buy them all ETH in group ETH /DAI on Uniswap.

In fact, you can't! You will pay an exponentially higher premium for each additional ether, but still can never buy all that money from the pool. Why? It's because of the formula x * y = k . If x or zero, meaning that if there is no ETH or DAI in the pool, the equation will no longer make sense.

But this is not the full story of AMM and liquidity pools. You will need to keep in mind one other thing when providing liquidity to AMM – temporary losses.

What is temporary loss?

Temporary loss occurs when the price ratio of deposited tokens changes after you deposit them in the liquidity pool. The larger the change, the greater the temporary loss. This is why AMM works best with similar value token pairs, such as or wrapped token.

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If the price ratio between the pair is maintained in a small range, temporary losses will be negligible. On the other hand, if the ratio changes a lot, liquidity providers may be better off holding the tokens. is to add money to a liquidity pool. Even so, Uniswap pools like ETH/DAI which are notorious for temporary losses are still profitable thanks to the transaction fees they accrue.

With that said, temporary loss is not a good way to name this phenomenon. Called “temporary” because if assets return to the price they were originally deposited at, losses will be mitigated.

However, if you withdraw your funds at a different rate than when you deposited them, the loss will be quite substantial. In some cases, transaction fees can mitigate this, but you should still consider all risks before making any investments.

Be careful when depositing money into AMM and make sure you understand the impact of temporary losses. If you want an overview and advanced on temporary loss

summary

Automated market makers are a staple in the space . Essentially, they allow anyone to seamlessly and efficiently create markets. Despite the limitations compared to order book exchanges, the innovation these tools bring to the crypto market is invaluable.

AMM is a stub. The AMMs that we know and use today like Uniswap, or PancakeSwap often have pleasant designs, but are still quite limited in features. In the future, many new designs for AMM may be created. This will lead to cheaper fees, less friction, and better liquidity for DeFi users.

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