One of the basic principles of cryptocurrency is decentralization. Many crypto holders and traders desire trustless trade. However, many custodians and centralized exchanges still operate with elements of centralization. Decentralized finance (DeFi) is designed to eliminate this problem.

Decentralized finance products such as decentralized exchanges (DEXs) are designed to operate without the need for any decentralized authority. But, how does this work? Who matches facilitates the process needed to provide liquidity on these trading exchanges? This is where automated market maker (AMM) comes in.

Automatic market makers (AMMs) are the underlying protocols that power decentralized exchanges. Uniswap became the first platform to implement an AMM system when it launched in 2018.

Let us take a look at what a market maker is before we delve deep into what AMMs are and how they work.

Market Makers

Centralized exchanges oversee traders’ operations and match trade orders accordingly. For example, when a trader wants to sell their bitcoins, the platform ensures that they are matched with another trader who wants to buy the same amount of Bitcoin at the price that the seller has set. Therefore, the centralized exchange act as an intermediary between the two traders. It is designed to make the process seamless for users.

However, sometimes the exchange may fail to match the buyer and seller orders instantly. In such a case, the exchange is said to lack liquidity for the specific asset pairs.

Liquidity in trading refers to how easily an asset can be traded (bought and sold). High liquidity refers to active markets with many buyers and sellers of a given asset. Low liquidity, on the other hand, refers to a less active market with low buying and selling of a given asset.

One of the problems with liquidity is that it can cause slippages. A slippage occurs when the price of asset changes significantly at the point of executing a trade. This often occurs when dealing with volatile markets such as crypto assets.

To avoid the problem of slippage, exchanges must ensure that trades are executed instantaneously. This can only happen when the exchange has enough liquidity at all times.

Centralized exchanges depend on professional traders and financial institutions to supply liquidity to the listed trading pairs. These traders create various bid-ask orders to match the orders of the rest of the platform users. In such a case, liquidity providers are the market makers.

Unlike centralized exchanges, DEXs aim to eradicate all intermediary activities in crypto trading. They do not operate with order-matching systems. Instead, they promote autonomy, enabling users to trade directly between themselves.

Instead of the order matching systems and traditional order books, DEXs uses AMM.

Automated Market Maker (AMM)

AMM are smart contracts that define asset prices and provide liquidity to the exchange. Smart contracts are self-executing computer programs that are deployed on the blockchain Network. Smart contracts are transparent and immutable.

AMM pools liquidity into smart contracts. These protocols enable a trader to trade against the liquidity locked in a smart contract rather than counterparties. Such smart contracts are called liquidity pools.

AMMs allow any user to participate in providing liquidity as long as they can meet the requirements contained in the smart contract. This is different from centralized exchanges, where only high-profile investors and companies can be liquidity providers. Some of the popular AMMs in the market today are Uniswap, Curve, and Balancer.

How Do Automated Market Makers Work?

Pools must have the liquidity to function properly, otherwise, they will experience slippages. Any user can provide liquidity to the pools. Most liquidity pools require liquidity providers to deposit both assets represented in the pool. For example, if you want to become a liquidity provider for ETH/XRP, you will need to deposit a given ratio of ETH and XRP.

The pools use mathematical equations to balance the asset ratio in liquidity pools. Various AMMs may adopt different formulas. For example, Uniswap uses the equation x*y=k to create the mathematical relationship between assets in the liquidity pools. Symbols x and y represent the value of the two assets and k is a constant.

Liquidity Mining

AMMs incentivize liquidity providers (LPs) to ensure that they supply enough liquidity to the pools. Pools that lack enough liquidity may suffer slippages. To avoid such cases, AMM rewards LPs with a fraction of the transaction fees collected on the platform. LPs’ earnings are proportional to their contribution to the pool. For example, you will earn 0.5% of the total transaction fees on the platform if you locked 0.5% on the pool.

Additionally, AMMs also issue LPs a governance token. Governance tokens enable holders to vote and define the future of the protocol.

Yield Farming

Yield farming offers LPs the opportunity to earn high rewards, besides the incentives mentioned above. Users only need to deposit assets on a liquidity pool. The protocol then sends the liquidity provider LP tokens. Some protocols even allow LP token holders to deposit or “stake” them on separate lending protocols for extra rewards.

Yield farming allows LPs to capitalize on the interoperability of DeFi protocols to maximize their earnings. Yield farming returns are often calculated as annual percentage yield (APY).

What is Impermanent Loss?

While AMMs may have various advantages, including decent earning opportunities, they are not free from challenges. One of the major risks of AMMs is impermanent loss.

Impermanent loss occurs when the price ratio of the assets in a pool fluctuates. The volatility in price causes the value of one or both cryptocurrencies in a pair to fall below the one at deposit. In this case, the holder suffers an impermanent loss.

The loss is called impermanent because it can disappear when the price returns. However, once the funds are withdrawn, it becomes a permanent loss.

An impermanent loss is common in DEXs since cryptocurrency is volatile. However, the potential earnings from transaction fees and yield farming can cover impermanent losses.

Final Thought

While AMM is highly useful within DEXs, they have some risks that traders and investors should understand. Therefore, it is important to research and understand the market and the DeFi services you are looking to invest in.