You could think of an automated market maker as a robot that’s always willing to quote you a price between two assets. Some use a simple formula like Uniswap, while Curve, Balancer and others use more complicated ones.
Not only can you trade trustlessly using an AMM, but you can also become the house by providing liquidity to a liquidity pool. This allows essentially anyone to become a market maker on an exchange and earn fees for providing liquidity. AMMs have really carved out their niche in the DeFi space due to how simple and easy they are to use. Decentralizing market making this way is intrinsic to the vision of crypto.
Decentralized Finance (DeFi) has seen an explosion of interest on Ethereum and other smart contract platforms like Binance Smart Chain. Yield farming has become a popular way of token distribution, tokenized BTC is growing on Ethereum, and flash loan volumes are booming. Meanwhile, automated market maker protocols like Uniswap regularly see competitive volumes, high liquidity, and an increasing number of users.
But how do these exchanges work? Why is it so fast and easy to set up a market for the latest food coin? Can AMMs really compete with traditional order book exchanges? Let’s find out.
What is an automated market maker (AMM)?
- An automated market maker (AMM) is a type of decentralized exchange (DEX) protocol that relies on a mathematical formula to price assets. Instead of using an order book like a traditional exchange, assets are priced according to a pricing algorithm.
- This formula can vary with each protocol. For example, Uniswap uses x * y = k, where x is the amount of one token in the liquidity pool, and y is the amount of the other. In this formula, k is a fixed constant, meaning the pool’s total liquidity always has to remain the same. Other AMMs will use other formulas for the specific use cases they target. The similarity between all of them, however, is that they determine the prices algorithmically. If this is a bit confusing right now, don’t worry; hopefully, it’ll all come together in the end.
Traditional market making usually works with firms with vast resources and complex strategies. Market makers help you get a good price and tight bid-ask spread on an order book exchange like Binance. Automated market makers decentralize this process and let essentially anyone create a market on a blockchain. How exactly can they do that?
How does an automated market maker (AMM) work?
An AMM works similarly to an order book exchange in that there are trading pairs – for example, ETH/DAI. However, you don’t need to have a counterparty (another trader) on the other side to make a trade. Instead, you interact with a smart contract that “makes” the market for you. On a decentralized exchange like Binance DEX, trades happen directly between user wallets. If you sell BNB for BUSD on Binance DEX, there’s someone else on the other side of the trade buying BNB with their BUSD. We can call this a peer-to-peer (P2P) transaction. In contrast, you could think of AMMs as peer-to-contract (P2C). There’s no need for counterparties in the traditional sense, as trades happen between users and contracts. Since there’s no order book, there are also no order types on an AMM. What price you get for an asset you want to buy or sell is determined by a formula instead. Although it’s worth noting that some future AMM designs may counteract this limitation.
So there’s no need for counterparties, but someone still has to create the market, right? Correct. The liquidity in the smart contract still has to be provided by users called liquidity providers (LPs).