Financial Education

What Is An Automated Market Maker?

April 19, 2021

One of the tools used most frequently in the decentralized finance (DeFi) space is the Automated Market Maker (AMM). AMMs facilitate decentralized transactions by using smart contracts to allow users to trade between assets. When someone decides to provide liquidity to an AMM or exchange, they are backing it with liquidity so users can trade between several different assets. The liquidity is used by smart contracts to balance and provide as close to an accurate price as possible when performing a transaction.

A few examples of AMMs in the DeFi space include Uniswap, Balancer, and Dodo, platforms that are making it simpler to trade decentralized assets at accurate prices. AMMs are a type of decentralized exchange that use advanced algorithms to facilitate trading between two assets. The formulas or algorithms used on an exchange to calculate asset prices vary, but all AMMs run on them so users can trade trustlessly. 


Why Use AMMs?

Traditional gatekeepers, such as health insurance companies and credit agencies, are one of many barriers to entry when sending or receiving funds. AMMs work around these obstacles, allowing users to interact directly with smart contracts on the blockchain instead of time-consuming counterparties. The market functions by using liquidity pools with mathematically balanced smart contracts instead of a financial institution like a bank or credit bureau. When users become liquidity providers on an exchange, they are facilitating trading on the exchange with smart contract-backed liquidity pools. This allows anyone to provide to the pool or trade on the exchange trustlessly. Put simply, the market is created by all of us, for all of us.

Using an AMM requires no “Know Your Customer” (KYC) information, streamlining the process of providing liquidity or simply trading. Those exchanges that use liquidity pools enable individual users to become market makers, replacing traditional asset reserves.

AMM Examples:

Uniswap uses a relatively simple algorithm utilizing multiple liquidity pools that aim to contain equal parts of two different assets. For example, an Ethereum and Dai pool enables users trading on an exchange to trade between these assets trustlessly and be quoted an accurate price. 


Another exchange called Balancer uses liquidity pools with more than two assets, assigning weights to each asset in order to balance the value of each asset in the pool. The weights assigned to each asset are applied with restrictions and don’t change when liquidity is added or removed from a pool.


Liquidity is needed in order for an exchange to process transactions, but the form it takes can differ and still provide an efficient experience. Dodo uses a type of price oracle, called a Proactive Market Maker (PMM) that navigates price discovery by behaving like human market makers and pricing assets as close to market price as possible. In doing so, impermanent loss or divergence loss experienced with other exchanges is removed from the equation.

Summary:

AMMs are some of the most popular protocols in the DeFi space, using advanced algorithms to provide efficient, decentralized, trading platforms. Though they differ slightly in application, the liquidity pools and oracles used to accurately price assets give anyone the opportunity to “become-the-market” so to speak, potentially profiting from price volatility and exchange fees. By quoting accurate asset prices measured by oracles and calculating prices with an algorithm-backed liquidity pool, smart contracts make AMMs easy to use. 

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