Automated Market Maker (AMM) - BlockchainAppsDeveloper
BlockchainAppsDeveloper - An automated market maker (AMM) is a decentralized exchange (DEX) protocol type that depends on a mathematical algorithm to price assets.
Automated Market Maker (AMM) - BlockchainAppsDeveloper
Nowadays, Decentralized Finance (DeFi) has greatly changed the way users buy and sell cryptocurrencies. The key way in which any Defi protocol operates is by utilizing an Automated market maker (AMM). AMMs play a significant role in assuring liquidity on the decentralized exchange. But, a lot of them outside may not be exactly familiar with AMM and how it works exactly. If you are one of those entrepreneurs looking to know more about AMM, its working model, and key applications, then read this blog. You will get insight into the vital concepts of AMM.
What is Automated Market Maker (AMM)?
Before delving into the main topic it is essential to understand the regular operation of Market makers. In a traditional financial market such as the stock market, market makers are trusted parties who provide liquidity between sellers and buyers. Liquidity refers to the ease with which an item can be sold or acquired.
A highly liquid cryptocurrency can be sold at a fair market price easily. Whereas an illiquid asset cannot be sold without any loss of value or significant effort. This means that if there is not enough liquidity, you will not be able to get the price originally wanted. This is why market makers are important in finance.
To make you understand better I will give an example here. Consider trader A who wishes to buy 1 bitcoin. The centralized exchange that manages the sale will have an automated mechanism that finds a seller, trader B who is ready to sell a bitcoin at the rate mentioned by trader A. Here, the exchange is operating as the middleman.
On the other hand, Automated market makers are part of DEXs (Decentralized exchanges) that were created to remove the need for middlemen in crypto asset trading. AMM can be said as the computer software that automates the liquidity supply. In contrast to regular market makers, AMMs use smart contracts - self-executing computer programs that set the price of crypto tokens mathematically and provide liquidity. So, this eliminates the requirement for another participant while making a trade. Automated market makers rely totally on liquidity pools and liquidity providers to function.
What is exactly a Liquidity pool?
It is a cryptocurrency reserve that is utilized to facilitate future trades. Those who give funds to these liquidity pools are known as liquidity providers. Instead of trading between sellers and buyers, users will trade against the liquidity pool. The more assets in a pool and the more liquidity the pool has, the trading will be easier on the decentralized exchanges.
Working of Automated Market Makers
To start with the working of AMMs, you need to understand two prime features of AMM.
The separate liquidity pools with AMMs will include trading pairings that would be normally found on the centralized exchange
By depositing assets described in the pool, any individual can supply liquidity to individual pools.
AMMs utilize pre-programmed mathematical equations to modify the prices depending upon the supply to ensure that the ratio of assets in the liquidity pool remains balanced. To make you understand better, I will mention an example here. In an ETH/BTC liquidity pool, a trader can purchase ETH by selling BTC. When the remaining supply of ETH in the liquidity pool goes down, the ETH price will go high in order to compensate. Also as there is more BTC in the pool its prices will go down due to the increased supply. In the reverse scenario, when BTC is purchased using ETH, the price of BTC will go up and ETC will fall in price.
The exact equation or formula depends on the Defi protocol. For example, Uniswap utilizes the x*y=k equation for setting the mathematical relationship between specific assets in the liquidity pools. In this equation, x is the quantity of one token in the pool and y is the quantity of another token. k is a fixed constant. Other Automated Market makers can also use complex mathematical formulas, supporting more than eight different asset classes to trade against each other in a single pool.
Who can become an AMM?
In a centralized exchange, only well-known firms and institutions can become market makers. But in AMMs anyone can become a liquidity provider if they fulfill the basic requirements. The requirements may vary between liquidity pools but you will need spare cash to make a key investment. Most smart contracts will need you to deposit a pre decided amount of tokens, normally Bitcoin, Ether, or Binance Coin.
In exchange for providing liquidity, Liquidity providers (LPs) will earn network fees from trading activities within their liquidity pool. But, LPs will receive only their share of transaction fees when they decide to pull their money out of the liquidity pool. Till then it will keep collecting on top of their existing deposit
Risk of Impermanent loss
Being an LP may sound like an easy way to earn transaction fees but there are some dangers involved with depositing the crypto. One of those risks is the impermanent loss that occurs when the price of the deposited crypto in a pool fluctuates from when it is deposited first. The greater the shift in price, down or up, the more will be the gain or loss when the deposit is withdrawn. It is not actually a loss for an LP until he withdraws, which is why this loss is referred to as impermanent loss.
I hope now you understand all key concepts about AMM, its working model, the role of liquidity pools and liquidity providers, and impermanent loss. Now you will be willing to know some main advantages of AMMs. Take a look below to know its benefits
Some popular Defi platforms that use AMMs are
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As said earlier, AMMs are the most significant innovations in decentralized finance. Without AMMs, crypto traders will be forced to rely on intermediaries and central exchanges and decentralized exchanges would not be possible. If you are an entrepreneur wishing to design this underlying protocol, then you can approach a leading blockchain development company like BlockchainAppsDeveloper. So, reach this renowned blockchain developer and set a strong foot in the Defi market.
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