Revolutionizing traditional markets through automated market makers
An Automated Market Maker (AMM) is essentially a type of DEX (Decentralized Exchange) and, as its name suggests, is the financial system’s way of automating trading by pricing its assets based on a mathematical formula. As part of the new wave of decentralizing financial services, an AMM seeks to revolutionize the trading process by ridding the process of order books and thus eliminating any kind of intermediary as well as the concept of buyers and sellers. In a time in which each millisecond counts, this new system brings forth not only faster but also less expensive transactions.
Optimizing a system inquires various changes to its process however, and as AMMs seek to remove traditional order books, aspects like the way prices are set for trades are subsequently revised. Indeed, traditionally, the price of a transaction would be set based on the asking price of a buyer and a seller. Unbalanced asking prices would be balanced and set to a common ground by the intermediary. Since AMMs remove this traditional landscape, new approaches are used to define the setting of the buying and selling price of assets. Many methods exist, but they are all based on the idea of using ratios to set these prices. The most know method represents a constant which defines the prices of two separate assets and relative to their amounts in a pool:
This representation was first brough to light by Ethereum’s founder Vitalik Buterin before being popularized by Uniswap (Cryptopedia, 2021). As per the formula, the higher the demand for an asset, also referred to as a token, the lower its quantity in the pool and thus the higher its price as opposed to the token it is dealt with considering the constant defining the balance. On the other hand, the lower the demand or the more users are willing to sell, the lower the price of the token will drop. This mechanism, also familiar as an economic concept, also introduces the opportunity of profitability through arbitrage which occurs when the price within the pool is not representative of the general market price. In this case, the reduced price of one of the two tokens incentivizes its purchase in the pool, bringing the balance back to the market’s valuation of the two tokens.
One of the principal concepts aforementioned is the pool. A liquidity pool is one that seeks to solve the issue of liquidity which made trading assets on the DEX for instance less attractive to many. Liquidity in this sense is representative of how sensitive assets are to price changes when they are bought or sold. To solve this problem and incentivize trading, liquidity providers are called upon, who are users who place an equal amount of two assets or tokens in a pool offering a liquid market in which individuals are more likely to trade in. In exchange for providing their funds in the market, liquidity providers are given a commission for trades that are placed within their pool. These fees can vary from 0.0001% to 10% depending on the provider, however, there exists an opportunity cost in the sense that the lower the commission, the greater the incentive for individuals to trade within the pool and vice versa (John, 2020).
As AMMs continue to grow in popularity, more variations were introduced. Of the most popular alternatives are Curve.fi and Balancer. Balancer improves on Uniswap by increasing the limit of tokens in a pool from 2 to 8, creating some sort of ETF. Moreover, Balancer allows users to add liquidity to a pool in exchange for earnings instead of having to control a single entire pool. All this however contributes to the complexity of the ratio’s formula. Curve.fi on the other hand focuses on offering trades for only stable coins that would incur less loss. For this reason, it uses an algorithm that is specific to this goal.
AMMs are still in early in their development and yet raise a lot of interest in multiple multinational companies. Their innovative solution for improving the imperfections of the traditional market are only the beginning to more continuous improvements which are brought to the space successively.
Cryptopedia. (2021, 03 14). What Are Automated Market Makers? Retrieved from gemini: https://www.gemini.com/cryptopedia/amm-what-are-automated-market-makers
John, J. (2020, 06 27). An Introduction To Automated Market Makers. Retrieved from Substack: https://cipher.substack.com/p/an-introduction-to-automated-market
Roots, S. (2020, 11 21). Automated Market Maker (AMM) Explained. Retrieved from Changelly: https://changelly.com/blog/automated-market-maker/