What Is an Automated Market Maker?
An Automated Market Maker, or AMM, is a tool that allows for permissionless and automatic trading of DeFi assets. They help increase liquidity and make trading more accessible.
The Long Definition
AAMs are designed to increase liquidity in DeFi asset trading by moving away from traditional user-to-user exchanges and setting up shared pools of tokens with prices set by an algorithm.
AMMs run on smart contracts and are underpinned by blockchain technology. This gives them a high level of decentralization and automation and opens up DeFi trading to a wider audience of users.
Diving Deeper: What Do AMMs Do?
AMMs represent a departure from the traditional way of trading crypto assets, where individuals buy and sell from each other.
Instead, AMMs rely on a pool of shared tokens called a liquidity pool. Users contribute tokens (called LP tokens) to this pool, and a mathematical formula sets the prices. This way, people can buy and sell crypto in a more decentralized and permissionless way without having to interact directly with other users.
You can think of AMMs as a little like a vending machine. You’re still buying something, and someone else is still getting paid, but many of the middle steps are removed, which makes the process more accessible and straightforward.
Why Is It Important?
AMMs have a few key benefits that set them apart from traditional ways of trading. Here are some of the main advantages.
- Liquidity. Trading crypto assets can be tricky if there aren’t many of them or if there isn’t a particularly high demand. Having a shared pool makes things easier by automating the process and providing constant liquidity
- Accessibility. AMMs allow for a truly global market so that anyone, anywhere in the world, can participate and trade with minimal barriers to entry
- Decentralization. AMMs are built on blockchain technology and underpinned by smart contracts, which gives them a high level of autonomy and decentralization — something that has always been a core part of the DeFi philosophy
What’s an Example of an AMM?
One of the most well-known examples of an AMM is Uniswap. Users can access thousands of different tokens and buy and sell them quickly and easily through the interface. The platform has an all-time volume of $2.2 trillion and has helped 16.6 million people trade tokens.
Challenges With AMMs
Despite their many advantages, AMMs also come with a few inherent challenges.
- Risk of impermanent loss. This is when tokens in the liquidity pool lose value due to market fluctuations, which can cause investors to lose more than if they had kept their tokens outside the pool. This can discourage asset owners from keeping their tokens in the pool during periods of high volatility.
- Slippage. This happens when there’s a difference between the expected price of a trade and the actual price, and is caused by volatility within the liquidity pool. Some AMMs allow users to set a limit for slippage to minimize these price differences. Focusing on smaller trades and higher-liquidity AMMs can also reduce the risk here.
- Security concerns, like the risk of “front-running attacks”. This is where malicious actors look at the list of pending transactions on the blockchain and then place their own transactions with higher fees to effectively skip the line. The result is that the victims can end up paying far more for tokens or receiving less than they paid for.
How Do AMM Fees Work?
AMM fees exist so that liquidity providers (the users who provide their tokens for the liquidity pool) are compensated.
These fees are paid to the AMM, and liquidity providers receive a percentage of this. Liquidity providers are able to vote for how high the fees should be, and it can vary depending on the AMM in question.
What’s Next for AMMs?
What does the future hold for AMMs? Like many things in the world of decentralized technology, it’s really only the beginning for AMMs.
In the coming years, you can expect to see tighter security controls, more cross-chain interoperability to trade tokens across networks, and higher liquidity due to infrastructure improvements.
