Automated Market Maker: A Detailed Guide 

The book defines: “A market maker is a firm or individual that stands ready to buy or sell a security (such as stocks, bonds, or options) at publicly quoted prices.” And Automated Market Maker is it’s automated counterpart. 

Moreover, their primary responsibility is to provide liquidity by continuously buying and selling securities. This ensures that buyers and sellers are always willing to trade.  

If you are still confused about how market makers make money, let us walk you through the complete process: 
In layperson’s terms, Market Makers make money by capitalizing on the bid-ask-spread. 

• Bid Price: This is the price at which you, as a potential buyer, are willing to purchase a stock.  
  
• Ask Price: Conversely, the Ask Price is the price at which you, as a potential seller, are willing to sell a stock. 

So, the bid and ask prices have a significant trade difference. Market makers buy shares at the bid price and sell them at the ask price, booking the difference. 

Ensuring Liquidity in the Market 

Market makers frequently quote bids and ask prices displayed on the exchange’s order book, which allows investors to review the current market conditions and decide whether to engage in trade. Hence, market makers provide valuable services for easy trade options for a product with low liquidity. 

Now that you are enlightened about Market Makers, let’s understand Automated Market Makers. 

Coinbase defines Automated Market Makers (AMMs) as the component of the Decentralized Finance ecosystem that enables the permissionless and automatic trading of digital assets.  

A more simplified overview that we will explore today in the blog. 

A Deeper Analysis of Automated Market Makers 

If you read our previous article on Decentralized Exchange (DEX), you will know how the decentralized market works. 
 
There’s no involvement of a single entity, and smart contracts carry out the whole crypto trading process. So far, unlike traditional centralized exchanges, the price of cryptocurrencies is determined by an algorithm using mathematical formulae. Something similar happens with Automated Market Makers.
 
AMM is a type of DEX that relies on algorithms to facilitate the trading of digital assets. Automated Market Makers strives to maintain liquidity in the DeFi ecosystem through liquidity pools. Additionally, participants supply these liquidity pools with crypto tokens, and mathematical formulas determine their prices. 

Traditional Trading Vs AMM Trading 

To understand the concept of AMM, let us walk you through an example. 
 
During a conventional exchange, buyers and sellers list the prices for assets like gold, stocks, or real estate. The exchange is usually termed a trade when buyers agree to the seller’s price, setting the market price for the asset. A process that relies on matching orders from individual participants. 
 
AMMs, used in DeFi and Ethereum, use liquidity pools instead of order books. 

Here’s an example: 

Traditional Exchange: Alice desires to purchase Bitcoin. She orders a purchase for $30,000. Bob is looking to sell Bitcoin. He puts in a $31,000 purchase order. When their prices coincide, a trade takes place. 
 
AMM Exchange: Alice wishes to exchange a token for Ethereum. Instead of going to a traditional exchange and searching for a seller, use a liquidity pool that other users support. Alice’s deal is immediately conducted, and the price is determined by AMM’s smart contract, which considers the pool’s supply and demand. 
 
This decentralized strategy adheres to blockchain principles and enables trading around the clock, providing a more open and independent trading environment. 

Advantages of Using AMMs

Automated Market Makers have several advantages over traditional market makers: 

• Continuous Liquidity: AMM provides ongoing liquidity for various assets, making it easier to trade less popular cryptocurrencies. 

• Open Participation: Anyone can provide liquidity to AMMs and engage in trading, often with lower fees than traditional exchanges. 

• Decentralization: It operates without centralized intermediaries, giving users more autonomy and ownership over their trades. 

Prominent AMMs in the Market 

Popular platforms like 

• Uniswap 

• Sushiswap 

• PancakeSwap 

• Balancer 

It provides some cool features and supported assets for offering robust liquidity, accessibility, and decentralized Automated Market Making solutions. 

Liquidity Pools & Liquidity Providers 

Liquidity is the ease with which one asset can be changed into another, frequently a fiat currency, without compromising its market value.  

Prior to the introduction of AMMS, liquidity was a problem for Ethereum decentralized exchanges (DEXs). Since it was a new technology with a complex interface, there were few buyers or sellers, making it difficult to find enough users willing to trade frequently. By establishing liquidity pools and providing liquidity providers with an incentive to contribute assets to these pools, AMMs address the issue of constrained liquidity. The number of assets and liquidity in a pool makes trading on decentralized exchanges more accessible. 

Hence, through AMM platforms, buyers and sellers trade against a pool of tokens rather than trading in between. Anyone can supply the liquidity pools with tokens, and their prices are determined by mathematical formulae that can be further optimized for a wide range of purposes.  

Anyone with an internet connection and any ERC-20 token can start providing liquidity by contributing tokens to an AMM’s liquidity pool. In most cases, liquidity providers receive payment for contributing tokens to the pool. Traders who deal with the liquidity pool must pay this fee. Through a method known as “yield farming,” liquidity providers have recently been allowed to earn yield in the form of project tokens. 

The Constant Product Formulae 

In the DeFi ecosystem, AMMs have taken the lead in asset trading, and it all started with Ethereum founder Vitalik Buterin’s blog article on “on-chain market makers.” A straightforward mathematical formula with multiple variations is the critical component of AMMs.  

Vitalik gave the most prominent one as: 

tokenA_balance(p) * tokenB_balance(p) = k 

And marketed by Uniswap as x * y = k 

The constant, denoted by “k,” indicates that the continuous balance of assets determines the price of tokens in a liquidity pool.  

For instance, if an AMM contains volatile assets such as ether (ETH) and bitcoin (BTC), its price increases each time ETH is purchased since there is now less ETH in the pool than before the purchase. On the other hand, when there is more Bitcoin in the pool, its price decreases. The total value of ETH in the pool will always equal the total value of BTC, maintaining the pool’s equilibrium. The pool will only get bigger if more liquidity sources join it.  

Variations of Automated Market Makers 

In his initial post, Vitalik Buterin emphasized that AMMs shouldn’t be the only choice for decentralized trade, advocating for automated or on-chain money markets. Instead, many token trading options were required, as non-AMM exchanges were essential to maintaining the accuracy of AMM values. What he should have anticipated, though, was the emergence of diverse strategies for AMMs. 

The DeFi ecosystem transformed rapidly, giving rise to three dominant AMM models: 

• The most enduring AMM model on Ethereum is Uniswap, whose innovative technology enables users to construct a liquidity pool with any pair of ERC-20 tokens in a 50/50 ratio.  

• Curve addresses the issue of restricted liquidity by generating liquidity pools of comparable assets, such as stablecoins. As a result, it provides some of the lowest rates and most effective trades in the market.  

• By enabling customers to build dynamic liquidity pools with up to eight distinct assets in any ratio, Balancer goes beyond the capabilities of Uniswap and increases the adaptability of AMMs. 

Despite being a new technology, Automated Market Makers have proven an essential financial instrument in the DeFI community, making a name for themselves in the thriving fintech market. 

FAQ 

1. How do AMMS work? 

AMMs use liquidity pools, where users can deposit cryptocurrency to create liquidity. The token prices in these pools are then determined by algorithms considering the asset-to-pool ratio. Users utilize the AMM to trade directly, exchanging tokens for one another at prices set by the pool’s algorithm. 

2. What are the advantages of using AMMs? 

• Liquidity: AMMs can provide continuous liquidity for a wide range of assets, making it easier to trade less popular cryptocurrencies. 

• Accessibility: Anyone can provide liquidity to AMMs and participate in trading, often with lower fees than traditional exchanges. 

• Decentralization: AMMs often operate without centralized intermediaries, offering greater autonomy and control to users. 

3. Which are the popular AMMs? 

Some of the popular AMMs include Uniswap, Sushiswap, PancakeSwap and Balancer. 

4. Do AMMs support fiat-to-crypto trading? 

No, AMMs majorly deal with crypto-to-crypto trading. 

5. What’s the future of AMMs in the crypto world? 

AMMs are becoming increasingly popular and have been a significant player in the DeFi (Decentralized Finance) arena. They include additional assets, provide new functions and interface with other DeFi protocols.