AMM stands for Automated Market Maker. In recent years, in the cryptocurrency market, developers have built many automated market-making platforms, known as AMMs. So, what is AMM? Let’s find out details with CoinMinutes through the article below.
What Is Automated Market Maker (AMM)?
AMM is an automated market maker. This is a trading method that uses algorithms to calculate token prices right at the time of purchase. This is a tool that automatically supports and connects cryptocurrency traders in a Decentralized form or is a form of creating a P2P (People to People) market to limit and overcome problems.
The Automated Market Maker mechanism does not have the concept of a seller, instead, smart contracts will act as intermediaries, the seller puts assets into a place called a liquidity pool, and then the buyer will swap the assets they have with them. assets in the pool through smart contracts.
AMM Protocol is often applied in decentralized exchanges (DEX) such as Uniswap, 1inch, SushiSwap, and Trader Joe,… although built on different blockchain ecosystems, they apply AMM Protocol to construction and development.
How Do Automatic Market Makers (AMMs) Work?
Automated Market Maker operates based on a protocol that applies a mathematical formula to price an asset instead of relying on the number of trading orders on centralized exchanges, where prices can be controlled by the asset owner.
For a simple example, on a regular exchange, you can place a buy or sell order at the price you set. When another investor wants to trade, the order will be matched and the transaction is completed. But with the Automated Market Maker automated market maker, it is different, the value of the currency is adjusted according to the algorithm. Therefore, the prices will be the same. You will not be able to place any buy or sell orders in advance. The order will be matched immediately when the investor has a need and places an order.
Specifically, Automated Market Maker is calculated using the formula x*y=k, where x and y represent the first and second liquidity pools, respectively, and k is the total liquidity and is always constant.
Simply put, when a user exchanges ETH for USDT, this means that the amount of ETH in the pool is more abundant and USDT is less than before. To ensure the ratio of assets in the liquidity pool remains as balanced as possible and eliminate discrepancies in the valuation of pooled assets, Automated Market Maker uses preset mathematical equations. When the amount of ETH in the pool increases, the price of ETH decreases to achieve the balancing effect of the formula x*y=k. On the contrary, because USDT was withdrawn from the pool, USDT price increased.
AMMs charge a small fee for each transaction, usually a small portion of that transaction. The generated funds are then shared among all the liquidity providers in that pool according to the proportion they contribute. A small portion of those fees will be retained for the purpose of developing and maintaining the protocol.
The Role of Liquidity Providers in AMMs
Automated Market Maker uses liquidity to maintain operations on the exchange. Because the above-mentioned pools do not have enough reserve capital, they will easily experience price slippage. To minimize the slippage that occurs, AMM DEXs encourage users to provide assets into pools so that other users can trade with these funds. These providers are called Liquidity Providers.
To incentivize Liquidity Providers to deposit their crypto assets into the protocol, AMM rewards them with a portion of the fees generated on the AMM, typically distributed in the form of LP tokens. The practice of a Liquidity Provider depositing assets to earn rewards is called yield farming.
Pros and Cons of Automatic Market Makers (AMMs)
- Provides a more efficient alternative to traditional order book exchanges and allows users to trade digital assets without the need for intermediaries. This is consistent with the decentralized economy that DeFi has been aiming for.
- AMM is highly automated. This means users do not need to worry about manually managing order books as they do on CEX exchanges. All transactions are performed automatically thanks to smart contracts.
- Anyone can become a liquidity provider and earn passive income from their idle crypto.
- Usually, the fee for using AMM will be lower due to optimizing the operating and operating costs of the system.
- AMMs are subject to slippage and temporary loss.
- The liquidity of newly launched coins is often poor. For newly launched coins with few investors, it will be difficult to guarantee or find liquidity pools for that coin.
- Difficult to use for newbies. Not everyone can easily get used to AMM. To get started, you will need to understand creating a non-custodial wallet, choosing a pool… Compared to creating an account and trading on CEX, this model is a bit more complicated.
Yield Farming Opportunities on AMMs
Yield farming is where Liquidity Providers deposit their cryptocurrency into AMM and receive LP tokens in return. In some cases, to increase the liquidity of these LP tokens, users can deposit or stake these LP tokens into a separate lending protocol and earn additional interest.
This way, you will manage to maximize your earnings by taking advantage of the composability or interoperability of DeFi protocols.
Above is a detailed article about Automated Market Maker (AMM) that CoinMinutes has compiled. This is an indispensable mechanism for developing more powerful decentralized exchanges. Hopefully, through the above sharing, you will have a clearer picture of AMM.