Automated Market Makers (AMMs) in Crypto: Everything to Know

By  Beluga Research September 8, 2023

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Summary

  • An Automated Marker Maker (AMM) is a decentralized exchange mechanism used to facilitate trading without traditional order books
  • This replaces traditional order books with algorithmically determined pricing and liquidity pools
  • AMM protocols provide liquidity for a wide range of tokens, allowing users to trade illiquid tokens without relying on centralized exchanges
  • AMMs have limitations such as impermanent loss, however, developers are exploring solutions to mitigate this issue

Overview

An "Automated Marker Maker" (AMM) is a decentralized exchange mechanism used to facilitate trading without traditional order books. AMMs are a key component of decentralized finance (DeFi) platforms, and users can trade assets directly from wallets, providing liquidity to these pools and earning fees in return.

AMMs have gained popularity due to accessibility and constant availability, but they can also exhibit "impermanent loss," a risk associated with providing liquidity in volatile markets.

A Brief History

Cryptocurrencies emerged in the late 20th century, but it was the introduction of Bitcoin in 2009 that showcased its true potential. Created by an anonymous individual or group known as "Satoshi Nakamoto," Bitcoin introduced the concept of a decentralized peer-to-peer (P2P) electronic cash system. It gained popularity as a store of value and medium of exchange, leading to the creation of alternative cryptocurrencies called "altcoins."

In the following years, various crypto projects aimed to address different aspects of the financial ecosystem. For example, "liquidity," or the ease with which an asset can be bought or sold in a market without significantly affecting the price, is a crucial component of the cryptocurrency market. Initially, centralized exchanges dominated trading, but they faced issues like a lack of transparency, custody risks and limited accessibility. These challenges led to the emergence of decentralized exchanges (DEX) and subsequently, AMM protocols.

AMMs: Everything to Know

AMM protocols are decentralized exchange mechanisms that use smart contracts for efficient and automated trading. Unlike traditional order book-based exchanges, AMMs rely on liquidity pools and algorithms. The most well-known AMM protocol is Uniswap, operating on the Ethereum blockchain.

In an AMM, liquidity providers (LPs) deposit funds into a pool, facilitating trades and earning a portion of the trading fees. Liquidity pools follow a constant product market-making formula called the "Automated Market Maker algorithm." This formula maintains the constant product of two assets in a pool, determining the trade price.

A key advantage of AMMs is providing liquidity for a wide range of tokens, including those with lower trading volumes. This feature allows users to trade relatively illiquid tokens without relying on centralized exchanges. AMMs eliminate the need for order books, matching buyers and sellers directly, reducing complexity and potential manipulation.

AMM protocols contribute to the decentralization of the cryptocurrency market. By operating on a blockchain, AMMs enable P2P trading without intermediaries, aligning with the core principles of cryptocurrencies and promoting financial sovereignty.

However, AMMs have limitations. Notably, impermanent loss occurs when the value of deposited assets in a liquidity pool fluctuates significantly compared to holding them individually. Impermanent loss can affect LPs' profitability, especially in volatile markets. Despite this, AMM protocols continue to evolve, with developers exploring solutions to mitigate impermanent loss.

Getting Started

To start with cryptocurrency, a user needs a digital wallet to store coins and a platform or exchange to buy and sell them. Digital wallets come in different forms, including "software wallets" that run on the user's computer or mobile device, "online wallets" hosted by third-party providers and "hardware wallets" for offline storage and enhanced security.

Once a user has obtained a wallet, they can acquire cryptocurrency by purchasing it from an exchange or receiving it in exchange for goods or services. Exchanges are online platforms where users can trade different cryptocurrencies using fiat currencies or other digital assets. It is important to choose a reputable exchange with strong security measures to protect personal funds.

Unique Aspects

Cryptocurrencies stand out from traditional money in a few ways. Firstly, they are decentralized and use blockchain technology for consensus and transaction validation. A blockchain is a transparent and tamper-resistant ledger that records all transactions across a network of computers.

Secondly, cryptocurrencies have a limited supply. Many, like bitcoin, have a maximum supply, meaning that no more coins can be created beyond this limit. This scarcity can increase the cryptocurrency's value over time as demand grows while the supply remains fixed.

Cryptocurrencies also offer privacy and pseudonymity. Transactions recorded on the blockchain are visible to all, but the individuals' identities are represented by cryptographic addresses instead of personal information. Note that some cryptocurrencies provide more privacy features than others.

Additionally, cryptocurrencies enable programmable money through "smart contracts." Smart contracts are self-executing agreements that enforce conditions written into the code. They enable various applications, such as DeFi, wherein users can engage in lending, borrowing and trading without intermediaries.

Advantages

  • Security . Cryptocurrencies use cryptography to secure transactions and control the creation of new units, making it difficult for hackers to tamper with them.
  • Decentralization . Unlike traditional banking systems, cryptocurrencies operate on a decentralized network called a "blockchain," which means that no single entity has control over the currency, making it resistant to censorship and government interference.
  • Transparency . Blockchain technology enables transparent and public transactions, reducing the risk of fraud and increasing trust among users.
  • Accessibility . Cryptocurrencies provide financial services to the unbanked and underbanked populations. Anyone with an internet connection can participate in cryptocurrency transactions, regardless of location or background.
  • Fast and Efficient Transactions . Cryptocurrency transactions are processed quickly, especially compared to traditional banking systems that involve intermediaries. Cryptocurrencies enable P2P transactions that are faster and more efficient.
  • Lower Transaction Fees . Cryptocurrencies often have lower transaction fees compared to traditional financial systems because they eliminate the need for intermediaries like banks or payment processors.
  • Financial Sovereignty. Cryptocurrencies give individuals full control over funds through private keys, allowing them to manage wealth independently.

Disadvantages

  • Volatility . Cryptocurrencies are known for price volatility, which can make them less suitable for stable transactions, as well as posing risks for investors.
  • Lack of Regulation . The decentralized nature of cryptocurrencies has made it challenging for regulatory bodies to establish clear guidelines, leading to uncertainties and risks for investors and opportunities for illicit activities.
  • Scalability . Scalability is a significant challenge for cryptocurrencies, as some struggle to handle the growing demand, resulting in slower transaction speeds and higher fees.
  • Energy Consumption . Some cryptocurrencies, like Bitcoin, rely on energy-intensive consensus algorithms, raising concerns about the environmental impact. Alternative consensus algorithms aim to reduce energy consumption.
  • Irreversibility of Transactions . Once a cryptocurrency transaction is confirmed and recorded on the blockchain, it is nearly impossible to reverse, which ensures system integrity but can be a disadvantage in cases of fraud or accidental transactions.
  • Adoption and Acceptance . Cryptocurrency adoption and acceptance are still relatively low due to factors such as complexity, regulatory uncertainties and lack of understanding. Education and improved infrastructure are gradually expanding adoption.