What Is an Automated Market Maker (AMM)?

In the realm of centralized exchanges, intermediaries play key roles, such as replenishing liquidity, executing orders, and orchestrating price adjustments. In stark contrast, these responsibilities fall under the remit of automated market makers on DEX platforms.

The heart of an AMM lies in its smart contracts—essentially programs containing liquidity pools, which are aggregations of assets, functioning based on a predefined mathematical formula. This formula helps to establish a pricing algorithm that mitigates intense volatility and maintains a balanced ratio of tokens within the liquidity pools.

Information about prices is fed into smart contracts through various avenues. Some examples include blockchain data oracles or the analysis of previous transactions.

To get the AMM system up and running, liquidity providers come into the picture. These are users who deposit their funds into smart contracts, thereby allowing the automated market maker to operate. In return for their services, they are awarded interest, as well as tokens known as LPs. These LP tokens serve as an assurance of the reimbursement of the provided funds. To maximize their returns from ‘fueling' the AMM, liquidity providers can stake their LP tokens.

When a trader utilizes a DEX, they interact with the automated market maker and pay a corresponding fee. This fee is then split between the exchange and the liquidity provider. Interestingly, traders don't have to hunt for a counterparty to execute a transaction—they directly trade with the smart contract.

Over the years, the DeFi market has seen the rise of two widely-adopted AMM templates, employed specifically by platforms like Uniswap and the Balancer protocol.

1. First caters to liquidity pools for pairs of tokens adhering to the ERC-20 standard. Thanks to the equation “x * y = k”, it ensures a balanced distribution of assets. In this equation, X and Y denote the quantity of the two assets in the pool, and K stands for the fixed total volume of liquidity. This format is the most widely used AMM model on the Ethereum network.

2. On the other hand, the second model enables the creation of flexible liquidity pools, accommodating anywhere from 3 to 8 crypto assets in various proportions. The governing formula adapts based on the number of assets. For instance, with three assets in the pool, the formula morphs into “(x * y * z) ^ (⅓) = k”.

Benefits and drawbacks

Aside from the mainstream cryptocurrencies, one can encounter rare and volatile assets in AMM pools, assets that are hard to locate on centralized exchanges. This brings about a wider scope of opportunities for traders.

One clear benefit for liquidity providers is the opportunity for yield farming. When they add funds to an automated market maker's smart contract, they receive interest rewards and LP tokens, which can be staked for passive income.

The prospect of arbitrage is another factor that attracts traders. Arbitrage is a trading strategy in which a market participant capitalizes on a temporary price discrepancy for the same asset across different exchanges. They buy where the price is lower and sell where it's higher.

Because the value of tokens in AMMs adjusts in response to supply and demand, it can differ from the prevailing market price. Arbitrageurs identify such pools and leverage them for their benefit. However, this practice also aids in maintaining the balance of assets within the automated market maker.

Finally, AMMs with substantial liquidity enable traders to avoid severe slippage (the difference in price between placing an order and its execution). Moreover, a trader can set a slippage limit while conducting a transaction.

Despite its benefits, AMM has its drawbacks. For instance, one risk associated with AMMs is ‘impermanent loss' for liquidity providers. This occurs automatically when the value of an asset in the pool fluctuates and deviates downwards from the price at which the provider had originally contributed funds.

This loss is termed ‘impermanent' because it's likely that the value ratio will readjust. However, if funds are withdrawn right after a price jump, there's a risk of locking in a loss.

Regardless of potential risks, as long as there are individuals and companies willing to act as liquidity providers, automated market makers will persist in supporting decentralized crypto trading.