DeFi

What are Automated Market Makers?

Automated market makers (AMMs) are nothing new. Starting in 2018 with Uniswap these platforms have made waves in the crypto space with upwards of $100 billion traded on these platforms.

They have become a key pillar in the decentralized finance (DeFi) ecosystem allowing any user the ability to trade in a truly transparent and permissionless way. In this article, we will be delving into the world of automated market makers. So without further ado, let’s dive right in.

In this article:

What are automated market makers?

Essentially, AMMs incentivize people to provide liquidity to decentralized exchanges. This capital is then locked in liquidity pools using smart contracts. This allows users to trade against the liquidity rather than using a traditional order book.

How do they work?

To understand AMMs let’s first look at how trading is done traditionally. In traditional finance, trading is done using order books. Buyers and sellers set a price which is then listed on a database. Then if another user finds this price acceptable they carry out a trade which ultimately determines the value of the asset.

In this system, a centralized exchange oversees the transaction. The exchange matches buy and sell orders quickly and seamlessly.

On the other hand, AMMs utilize liquidity pools. Now you may be wondering, what are liquidity pools? As outlined in my previous article. Liquidity providers (LPs) pool up cryptocurrencies. This pool is essentially a pile of funds that users trade against.

Once liquidity is provided, their funds get locked and they receive liquidity provider (LP) tokens. A smart contract distributes a percentage of the trading fees to the LPs as rewards. In order to unlock their funds and the rewards, they have to redeem their LP tokens. The larger the pool the smaller the slippage.

Ultimately, users are trading with the liquidity locked in the smart contracts. This removes any intermediary. This allows AMMs to be completely decentralized, permissionless, and transparent.

Pros

Efficiency – AMMs are operating 24/7. Smart contract technology allows trades to be paid out automatically. Not to mention, this is all done peer-to-contract rather than peer-to-peer. Therefore, there is no delay in transfer and it skips any arduous administrative process which may hinder the speed of trading. Ultimately, this creates an extremely efficient system.

Permissionless – as mentioned previously, anyone can access liquidity pools. Unlike traditional finance, users are not excluded by a central authority. There is no KYC or application process. This alternative is open to all. The permissionless nature of AMMs also leads to cheaper trading as there is no broker taking a trading fee.

Democratization of power – AMMs are governed by decentralized autonomous organizations (DAOs). Essentially, these are formed by token holders of the platform who vote on proposals to ensure more secure protocol development. Ultimately, the decision-making is done across the whole community rather than a select few stakeholders. If you want to learn more about governance tokens click here.

Transparent – all transactions on the blockchain are transparent. Therefore, you know if the smart contract is working as intended or if someone is performing illicit activities.

Cons

Impermanent loss – essentially, impermanent loss happens when the price of a token rises or falls after you have deposited it into a liquidity pool. The greater the price change the greater the impermanent loss. This occurs as liquidity providers are only entitled to a share of the pool. If the total pool decreases so will your share.

Hacks – the second risk is nothing new, hacks. If you interact with a fake website or shady smart contracts your wallet may get compromised. Research is key. Find reputable AMMs and don’t fall for the common scams. The best way to protect yourself from hacks is using a hardware wallet. The one that I recommend is the Ledger Nano X. Click here to read my review.

Top 3 automated market maker platforms

Uniswap – founded in 2018 by Hayden Adams, this is by far the biggest decentralized exchange with over $90 million in daily volume. This AMM allows anyone to trade with no middleman. The protocol is also governed by UNI token holders who vote on proposals put forward by the community. This creates a truly decentralized application. Not to mention, there is a grant program that funds projects building on top of the protocol. Paired with the excellent development team this has created a very reputable AMM.

1inch – like Uniswap, 1inch has a strong reputation in the crypto industry with investments from major VCs. This includes over $100 million in backing from the likes of Binance, Alemeda Research, and Pantera Capital. The protocol works by aggregating liquidity from other DEXs and private LPs. This allows competitive exchange rates with low slippage. Not only that, but it’s extremely cheap. The protocol does not charge a fee for trading, withdrawal, or deposits.

PancakeSwap – unlike the other two protocols, PancakeSwap is based on Binance Smart Chain (BSC). It is the largest BSC AMM with over $2.5 billion locked up. The platform has been audited by Certik and Peckshield making it extremely secure. Not only is it an AMM but PankcakeSwap also includes an NFT marketplace and a launchpad where the community can launch their own projects. As it is a BSC project the transaction fees are as low as $0.15. Therefore, If you want a cheap alternative to Ethereum-based AMMs then Pancake Swap is the place to trade.

Conclusion

Overall, AMMs are an effective way to provide liquidity to traders without the need for a third party. It’s permissionless and transparent which provides a fair and democratic system open to all.

Although there are certainly problems in the space with hacks and impermanent loss, the continued development with the likes of Uniswap and PancakeSwap is really propelling the space forward. This has made me extremely optimistic about the future of AMMs and DeFi as a whole. Thanks for reading.

If you want to learn about decentralized insurance, please click here.