Automated Market Maker (AMM): The Role of This Liquidity Conduit in DeFi
Updated: Sep 16
Have you ever wondered how Decentralized Exchanges process trades and discover prices? If you are still stuck in the loop, these platforms employ a unique set of computer programs known as AMM, a.k.a Automated Market Maker, to facilitate transactions.
Decentralized financial markets are gaining traction due to their ability to disintermediate transactions. Unlike the traditional systems, Decentralized Finance uses AMM to enable a fluid system that borders on autonomy, liquidity, and automation, allowing anyone to earn fees for providing liquidity.
But how do these protocols' function? Why is it so quick and simple to establish a market for the latest food coin, and how do mainstream AMM like Uniswap change the dynamics of decentralized exchange? Let's find out how.
What is an Automatic Market Maker?
An automatic Market Maker (AMM) is a decentralized exchange protocol that allows digital assets to get traded permissionless and automatically. This protocol uses liquid pools rather than the traditional system of buyers and sellers.
AMM is a financial instrument unique to Ethereum and decentralized finance (DeFi). This new technology is decentralized, always available for trading, and does not rely on traditional buyer-seller interactions. This inventive mode of exchanging assets embodies the ideals of Ethereum, crypto, and blockchain technology: no single entity controls the system, and anybody can build and participate in new solutions. The Automated market makers depend on liquidity pools and providers to function correctly.
What is a Liquidity Pool?
A liquidity pool is a smart contract or a cryptocurrency reserve to facilitate future trades. On the other hand, liquidity providers provide these funds to pools.
Liquidity pools mainly accept two Cryptocurrencies, namely BTC and ETH. These tokens are exchanged in the same way Forex traders buy and sell currency pairs. For instance, using an AMM, a trader can, for example, sell Bitcoin to buy Ether and vice versa from a BTC/ETH liquidity pool.
However, if there isn't enough liquidity on the market to instantly match buy and sell orders, slippage can occur when an asset's price shifts before the trade get completed. Slippage sets in when the processing of large order volumes drives the prices of an asset up or down.
Some Liquidity pools and AMM accept other distinct Cryptocurrencies simultaneously. It all depends on the AMM and decentralized exchange you use.
How Do AMM Work?
Unlike the traditional Order book exchange, you do not need to have a counterparty on the other side to facilitate a trade. Instead, you interact with your smart contract, which automates your trading process. You can think of this protocol as a peer-to-contract (P2C) protocol.
AMM uses preset mathematical formulas to ensure the ratio of assets in liquidity pools remains as balanced or harmonious as possible and to eliminate discrepancies in pooled asset pricing. Protocols such as Uniswap have gained much traction in the last months.
Uniswap uses the X * Y = K equation where X denotes the value of Assets A, Y indicates the value of assets B, and K is a Constant. This equation implies that regardless of changes in the value of assets A or B, their products must always be equal to a given constant.
Let's look at an ETH/USDT liquidity pool as an example to see how this works. When traders buy ETH, they add USDT to the pool and remove ETH from it. This process reduces the amount of ETH in the pool, causing the price of ETH to fulfill the balancing effect of x * y = k. In contrast, as more USDT gets added to the pool, the price of USDT falls. When USDT is purchased, the cost of ETH in the pool decreases while the price of USDT increases.
The Uniswap protocol remains the most prominent and extensive AMM, especially as new applications get added to the platform. The most current of these applications is the foray into the world of digital art - NFTs, using Sudoswap.
Uniswap Integrates Sudoswap to Access Deeper NFT Liquidity
As the leading decentralized exchange in the crypto market, Uniswap is integrating the decentralized NFT marketplace - Sudoswap, to effectuate an efficient NFT liquidity when the Uniswap NFT platform launches.
Sudoswaps Automatic Market Maker platform, fondly called sudoAMM, allows users to buy NFTs on the Uniswap platform while benefiting from the on-chain liquidity.
Contrary to order books that are susceptible to downtime and centralization risks, sudoAMM is decentralized and on-chain, which means anyone, once they have Ethereum, can source the same liquidity used by the Sudoswap marketplace.
Automated Market Makers address the flaws in traditional market-making. The conventional method necessitates manual labor, which takes considerably longer for traders and market makers. The decentralized finance industry has advanced significantly as a result of this new source of liquidity.
AMM will continue to play an essential role in the development of DeFi as it proliferates. Only a few companies are currently offering practical solutions in the AMM space. Because of their ease of use, AMM has undoubtedly carved out its territory within DeFi.
What are your thoughts? Do you think AMM is an effective Decentralized Finance tool to boost liquidity on the Blockchain?
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