What is an Automated Market Maker (AMM)?

In a conventional exchange, market makers purchase and sell assets to maintain liquidity and streamline trades. Users can have trouble selling their assets at a fair price without liquidity. Decentralized exchanges do not rely on traditional market makers. AMMs solve this problem by using liquidity pools.

In this article, we will have a closer look at how an AMM works, what it does, and why it is important.

What is an AMM?

One of the most important differences between decentralized exchanges (DEXs) and centralized exchanges (CEXs) is how they operate. A CEX requires a user or entity to run it, and on the other hand, a DEX can run by itself as long as it has liquidity.

The use of order matching systems and order books is essential to centralized exchanges; however, decentralized exchanges utilize autonomous protocols that are referred to as Automated Market Makers (AMMs). The pricing of digital assets and the availability of liquidity are both determined by these protocols through the utilization of smart contracts.

DEX users trade against the liquidity that is locked within these smart contracts, which are frequently referred to as liquidity pools. This is in contrast to centralized exchanges, where traders match orders with other users at the same time.

Significantly, becoming a liquidity provider in AMMs is not restricted to high-net-worth individuals or organizations; any individual can join as long as they match the requirements that are coded into the smart contract.

How Does an AMM Work?

The central limit order book model is a concept that is used on traditional exchange platforms. On these platforms, buyers and sellers offer different prices for an asset, and those orders are matched with each other based on the order book of the exchange.

When it comes to the execution of orders, traditional exchanges rely on liquidity that comes from either their reserves or from an individual market maker.

AMMs rely on this liquidity. In liquidity pools, liquidity providers "lock" equal amounts of two or more tokens into a smart contract so that they can be utilized as liquidity for trades made by other users.

The use of AMMs has been the predominant method for trading tokens throughout the DeFi ecosystem. Many AMMs employ a formula known as the "constant product" to maintain the prices of tokens that are exchanged in liquidity pools at a consistently

A self-custody wallet and the possession of any tokens that are compatible with the pool are the only requirements for participation in a liquidity pool. When users lock their tokens in liquidity pools, they are rewarded with a portion of the trading fees earned by that tool. This provides an incentive for users to contribute their tokens.

Liquidity Providers And LP Tokens

Whoever launches the AMM is the first liquidity provider, and they are awarded LP Tokens, tokens that reflect 100% ownership of the assets contained within the AMM's pool.

They can remove assets from the AMM by the amounts that are currently there so that they can redeem any or all of those LP Tokens. Any individual can contribute assets to an established AMM. If they do so, they are rewarded with new LP Tokens proportional to the amount of money they deposited.

The percentage of an AMM's LP Tokens that a liquidity provider owns compared to the total number of LP Tokens in circulation determines the maximum amount of money that can be withdrawn from an AMM by that liquidity provider.

Applications of AMMs

Consistent Access to Liquidity

An AMM's capacity to supply ongoing liquidity is one of its key benefits. The availability of assets for trading is guaranteed by liquidity pools, which do not care about time or market conditions. Users of AMMs can trade quickly, in contrast to conventional exchanges that depend on individual buyers and sellers.

Easy LP Entry

Anyone with tokens can become a liquidity provider with the use of AMMs, which decentralize trading. High entry barriers in traditional markets mean that only large, well-established companies and banks may participate. As an alternative, AMMs allow users to engage in the market and earn fees by contributing their tokens to liquidity pools, therefore allowing them to earn passive revenue.

Reduced Fees

In comparison to more conventional exchanges, AMMs usually have more affordable fees. The use of AMMs automates trading and eliminates middlemen, which in turn lowers the price of order matching and other services offered by centralized exchanges. Traders and liquidity providers alike will reap the financial rewards of this cut, as trading becomes more accessible and lucrative.

Security and Decentralization

There is no longer a requirement for a middleman or governing body because AMMs run on blockchains or distributed ledgers. Because of its decentralized design, security is improved and the possibility of failure at any one location is removed. There is less chance of hacking or manipulation of funds because users have complete control over their assets and can trade straight from their wallets.

Choice of Tokens

Even though there is a vast and ever-increasing number of cryptocurrencies, only a very small percentage of them are supported by central trading platforms. As long as there is the potential for liquidity to be incentivized, AMMs can fill the void in the market because there are no constraints on the types of cryptocurrencies that can be listed.

What's Ahead For AMMs

To address particular functional concerns, such as the issue of capital inefficiency, automated market makers are now undergoing technological advancements. Users of new DEXs are given the ability to specify price ranges between which they would like their cash to be distributed. The market for liquidity provision is becoming significantly more competitive as a result of this, which is expected to result in a greater degree of segmentation among DEXs.

At the same time that the functionality of AMM is being improved and innovated, the user experience of decentralized exchanges that sit on top, which is a clunky and confusing experience, will swiftly advance to eliminate the friction that limits adoption.

Final Words

Automated market makers, also known as AMMs, are a component of the ecosystem that is known as decentralized finance (DeFi). Instead of a typical market consisting of buyers and sellers, they make it possible for digital assets to be traded in a manner that is both permissionless and automatic through the utilization of liquidity pools.

Users who participate in AMM contribute crypto tokens to liquidity pools. The prices of these tokens are decided by a mathematical formula that is constant. There are a variety of applications that can be optimized for liquidity pools, and they are proving to be a significant instrument in the ecosystem of decentralized finance.

That's it. Read more about the DeFi and cryptocurrencies in our blog section.