What Are Automated Market Makers (AMMs) and Why Its Important for DeFi

What Are Automated Market Makers (AMMs)?

AMMs are a type of protocol designed to facilitate the trading of digital assets and the setting of asset prices on decentralized exchanges (DEXs). Instead of matching buyers and sellers as in traditional order books, AMMs utilize liquidity pools and mathematical algorithms for trade execution and price determination. 

How Do AMMs Work?

Typically, a market maker refers to an entity (firm or individual) who facilitates the process of liquidity provision by submitting both bid and ask orders for a specific asset on centralized exchanges. Crypto market makers place orders around the prevailing market price of the token at the time, in order to increase the chances of traders’ orders being matched. These entities help maintain the efficiency and fluidity of a centralized exchange’s trading system. Now, the operation of traditional market makers forms the core of AMMs’ mechanism, except that the latter is automated and uses individual liquidity providers (LPs). Automated market makers provide liquidity through smart contracts — self-executing protocols — commonly called liquidity pools. Instead of trading against counterparties, users trade against the liquidity pools — a reservoir of tokens supplied by the LPs — on AMM platforms. For example, if a DEX user wanted to exchange Ether (ETH) for Tether (USDT), they would need to find the ETH/USDT liquidity pool on the automated market maker. The “market price” of the trade depends on the relative ratio of the amount of tokens within the liquidity pool. Using the earlier example, a pool with 1ETH and 3000USDT would represent an ETH price of $3,000. Trades executed on the pool would shift this ratio, representing shifts in the market price.

Benefits of Automated Market Makers

Decreased Liquidity Requirements

The primary advantage of the Automated Market Maker (AMM) model is its significantly lower liquidity requirements compared to traditional order book systems. AMMs can support smooth trading with just a fraction of the liquidity needed in traditional markets. This is important because as a novel industry the amount of liquidity in cryptocurrency markets is limited.

Decentralization

Automated market makers eliminate the need for intermediaries and third-party custodians, enabling users to retain control of their assets. This aligns with the decentralized ethos of the cryptocurrency industry, ensuring a trustless and permissionless trading ecosystem.

Lower Entry Barrier

In centralized trading platforms, only high-net-worth entities are able to provide liquidity through “market making.” Automated market makers, on the other hand, can accept trades and even liquidity provisioning regardless of the amount. Moreover, there are decent incentives attached to being an LP on AMMs.