Ethereum and other smart contract systems, such as Binance Smart Chain, have experienced a surge in interest in decentralized finance (DeFi). Yield farming has become a popular method of token distribution, tokenized BTC is gaining popularity on Ethereum, and the number of flash loans is increasing.
Meanwhile, automated market maker protocols like Uniswap see large volumes, liquidity, and a growing number of users on a regular basis.
But how do these interactions take place? Why is it so simple to build up a market for the most recent food coin? Is it possible for AMMs to compete with traditional order-book exchanges? Let's have a look.
What is an automated market maker (AMM)?
A decentralized exchange (DEX) protocol that uses a mathematical formula to price assets is known as an automated market maker (AMM). Assets are valued using a pricing algorithm rather than an order book like a traditional exchange.
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.
Market making in the traditional sense is usually done by companies with a lot of money and complicated tactics. Automated market makers decentralize the process, allowing almost anyone to start a blockchain market. How are they going to do it? Let's continue reading.
How does an automated market maker (AMM) work?
There are trading pairs in an AMM, just like there are on an order book exchange — for example, ETH/DAI. To make a transaction, however, you don't require a counterparty (another trader) on the other side. You interact with a smart contract instead, which "creates" the market for you.
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 formula instead. Although it’s worth noting that some future AMM designs may counteract this limitation.
So, without needing any counterparties, but still has to create the market. The liquidity in the smart contract still has to be provided by users called liquidity providers (LPs).
Generally, automated market makers are a staple of the DeFi space. They enable essentially anyone to create markets seamlessly and efficiently. While they do have their limitations compared to order book exchanges, the overall innovation they bring to crypto is invaluable.