Automated Market Makers (AMMs): Everything to Know

By  Beluga Research July 17, 2023

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Summary

  • An automated market maker (AMM) helps foster trading on a decentralized exchange (DEX)
  • An AMM allows users to trade cryptocurrency without a third-party such as a bank
  • These AMMs use a special algorithm to set prices for trading pairs
  • AMMs are facilitated by smart contracts and charge users transaction fees

Overview

AMMs, or automated market maker, are protocols for decentralized exchange (DEX) to make it possible for users to trade cryptocurrency without a middleman. AMMs offer liquidity for users who want to make a trade. An AMM eliminates the need for a third-party financial institution to get involved in a trade. AMMs aid traders and investors in the cryptocurrency space.

A Brief History

A group of researchers at the University of California, Berkeley introduced the concept of AMMs in 2013. The group termed the system an "automated market maker" because it would use an algorithm to set prices for trading pairs.

Bancor, a decentralized exchange, launched the first AMM implementation in 2016. Bancor's AMM was designed to provide liquidity for trading pairs unavailable on centralized exchanges. Bancor's AMM was built on the Ethereum blockchain with its own cryptocurrency called the BNT token.

Since then, other groups have launched a number of other AMMs. These include Uniswap, SushiSwap and Curve Finance. AMMs have become increasingly popular in the cryptocurrency space.

What is an Automated Market Maker (AMM)?

An automated market maker (AMM) is a protocol for a decentralized exchange of cryptocurrencies. AMMs utilize an algorithm to set prices for trading pairs. An AMM uses something called a liquidity pool to facilitate trades of digital assets.

For each AMM, the liquidity pool consists of two digital assets. Users will trade these assets according to the terms of the smart contract. Typically, a stablecoin and another cryptocurrency are in the liquidity pool. The AMM's algorithm calculates a rate of exchange based on the values of the two assets in a liquidity pool.

The prices of each respective asset in the liquidity pool is determined by the market. An asset's price will fluctuate based on supply and demand. Every time a user makes a trade, a fee for the transaction must be paid.

Getting Started

  • Connect a cryptocurrency wallet to a decentralized exchange. A user typically accomplishes this through a web3 provider such as MetaMask or WalletConnect.
  • Select tokens to be traded. The user should input the amount of tokens they want to buy or sell. The AMM will use its formula to determine the price and execute the trade.
  • Benefit from the AMM's lack of centralization. A user is not required to find a trading partner when using a DEX. The AMM will match with another user who wants to make a trade. Since there is no central authority controlling the interaction, the exchange between the users is more resistant to censorship and hacking.

Unique Aspects

  • Method of determining prices. AMMs use a mathematical formula to determine price based on the ratio of tokens in the liquidity pool. Traditional exchanges rely on order books to match buyers and sellers at a specific price point. The AMM's formula is called the constant product formula. It ensures that the value of each token in the pool remains constant.
  • Incentivize liquidity providers. Liquidity providers earn a portion of trading fees generated by the AMM. They do not pay fees to an exchange. A user can earn passive income by providing liquidity to the pool.
  • The potential of greater price slippage. This is possible when users trade high numbers of tokens. Since liquidity is pooled from multiple users, the pool can be drained if too many users withdraw their funds at once.

Advantages

  • Liquidity. There is a high level of liquidity for traders with AMMs. The protocols allow anyone to become a liquidity provider by depositing their assets into the pool. Traders can easily buy and sell assets without having to wait for a buyer or seller to present themselves.
  • Accessibility. These AMMs are accessible to anyone with an internet connection and a cryptocurrency wallet. This makes it easy for a user to trade crypto assets without having to deal with a centralized exchange or financial institution.
  • Transparency. AMMs are transparent. The price of assets is determined by a mathematical algorithm that is publicly available. Traders can see exactly how the price of an asset is determined. They do not have to rely on the opaque pricing mechanisms of traditional exchanges.
  • Security. AMMs are decentralized. There is no central point that can be attacked by hackers or malicious actors. This makes AMMs more secure than centralized exchanges, which are often targeted by hackers.
  • Low fees. An AMM typically has lower fees than traditional exchanges. This is because there are no middlemen involved in the trading process. Traders can save money on trading fees, which can add up over time.

Disadvantages

  • Impermanent loss. Liquidity providers on AMMs are subject to impermanent loss. This occurs when the price of an asset changes relative to another asset in the pool. Liquidity providers may end up with less of the asset they initially owned. This is true even if the overall value of the pool has increased.
  • Limited asset selection. There is usually a limited selection of assets available for trading with AMMs. They rely on liquidity providers to deposit assets into the pool. Traders may not be able to find the assets they want to trade on an AMM.
  • Price slippage. AMMs are subject to price slippage. This occurs when the price of an asset changes rapidly due to market volatility. Traders may end up buying or selling an asset at a higher or lower price than they initially intended.
  • Front-running. An AMM can be vulnerable to front-running. This is the name for the act of a user accessing privileged information to place their own trade before a pending trade. Front-running is typically illegal. The practice results in unfair trades and usually leads to losses for other traders.