The Rise of Automated Market Makers (AMMs) in Web3

Blocksurvey blog author
May 18, 2024 · 3 mins read

One of the most innovative components of the decentralized era is the rise of Automated Market Makers (AMMs), which are redefining how transactions occur without traditional intermediaries.

This blog explores how AMMs are enhancing user interaction and community engagement in unprecedented ways.

Let’s start.

Automated Market Makers

What is a Market Maker?

A market maker provides liquidity for trading pairs in centralized exchanges. If Trader A plans to buy a particular crypto, the exchange ensures that Trader B can sell that crypto at Trader A’s preferred exchange rate.

When the exchange cannot find suitable matches for buying and selling orders, then lower liquidity (harder to buy and sell assets) and slippage (shifting of prices) can occur. Market makers facilitate the processes required to provide liquidity for trading pairs.

What is an Automated Market Maker?

Decentralized exchanges (DEXs) replace order-matching systems with autonomous protocols called AMMs. These protocols use smart contracts - self executing computer programs to provide liquidity. These smart contracts are called liquidity pools.

Notably, only high-net-worth individuals or companies can assume the role of a liquidity provider in traditional exchanges. As for AMMs, any entity can become liquidity providers as long as it meets the requirements hardcoded into the smart contract.

How do AMMs work?

Each liquidity pool typically contains two types of tokens and maintains a constant relationship between these tokens, defined by a mathematical formula.

AMMs use pre-set formulas to determine the price of assets. The most common formula used is X * Y = K, where X and Y represent the quantity of the two different tokens in the liquidity pool, and K is a constant.

how does automated marker work

Source: Coindesk

If a trader wants to buy 1 ETH from this pool, they need to add DAI to the pool so that the product of the amounts of ETH and DAI still equals K. If the trader adds 204.08 DAI to the pool (so there are now 20,204.08 DAI), the new ETH amount needs to adjust to maintain K. The equation becomes 99×20,204.08≈2,000,000, so the price of 1 ETH in this trade ends up being approximately 204.08 DAI.

AMMs represent a shift from traditional market dynamics to algorithm-driven trading mechanisms that use liquidity pools and mathematical formulas to manage and facilitate trades in the decentralized ecosystem.

Advantages of AMM

Permissionless

Automated Market Makers (AMMs) allow anyone with internet access to become a liquidity provider or trade tokens, fostering financial inclusion and democratizing access to investment opportunities. This accessibility helps broaden participation in the global financial market.

Reduced Slippage

Large liquidity pools help minimize slippage, thus stabilizing prices for traders. By increasing the volume of assets in the pool, they allow for larger trades to occur without significantly impacting the asset's price, ensuring more predictable and consistent pricing for all participants in the market.

Increased Liquidity

Automated Market Makers (AMMs) incentivize users to deposit tokens into liquidity pools. This strategy guarantees that liquidity is consistently available, enabling traders to execute transactions smoothly and efficiently at any time.

No Counterparty risk

Trading occurs directly with the smart contract, removing the necessity for trust between buyers and sellers. This system bypasses traditional intermediaries, ensuring that transactions are executed automatically and transparently based solely on predefined rules encoded in the smart contract.

Challenges in AMM

Impermanent loss

Impermanent loss is a key challenge for liquidity providers in AMMs. It occurs when the prices of tokens in a liquidity pool significantly diverge, affecting the value of assets compared to holding them separately in a wallet. This loss happens because the pool's asset balance shifts from the initial deposit, potentially leading to a lower value upon withdrawal. Liquidity providers face risks of decreased asset value due to market volatility and price changes of the pooled tokens.

Limited Asset Coverage

AMMs generally function within certain ecosystems, like the Ethereum network, and only support the tokens available in those systems. This can result in limited asset coverage, as not all cryptocurrencies or tokens are accessible for trading on AMMs. This limitation may affect the liquidity and accessibility of assets, particularly those not on prominent blockchain platforms, potentially hindering the broader reach and effectiveness of these market makers.

Smart Contract Vulnerability

Automated Market Makers (AMMs) rely on smart contracts to manage and facilitate trades, making them susceptible to vulnerabilities inherent in their code. These flaws can lead to security breaches, allowing malicious actors to exploit contracts, potentially resulting in significant financial losses. Ensuring the integrity and security of these contracts through rigorous testing and audits is crucial, as any oversight can compromise the safety of user funds and undermine trust in the ecosystem.

Front running

Front-running in AMMs involves traders exploiting knowledge of upcoming transactions by executing similar trades first to benefit from subsequent price changes. This practice, observed through pending transactions on the blockchain, undermines the fairness and integrity of AMMs by taking advantage of price movements before the original transactions are processed.

Scalability

Scalability is a big challenge for blockchains and affects Automated Market Makers (AMMs) too. When more people use an AMM, it can overload the blockchain, causing delays and higher fees. For AMMs to be practical and efficient in the long run, they must handle lots of transactions quickly and keep delays low.

Conclusion

AMMs bring fluidity and efficiency to digital transactions, making them indispensable in a decentralized environment. Understanding and leveraging AMM is crucial.

As blockchain technology continues evolving, so will AMM, heralding innovation.

Write to [email protected] for suggestions and feedback.

The Rise of Automated Market Makers (AMMs) in Web3 FAQ

What is an Automated Market Maker (AMM)?

An AMM is a type of decentralized exchange protocol that uses smart contracts to create liquidity pools.

How do Automated Market Makers work?

AMMs use algorithms to automatically set prices based on the ratio of assets in a liquidity pool.

What are the benefits of using an Automated Market Maker?

AMMs provide continuous liquidity, lower fees, and reduced slippage compared to traditional exchanges.

Are there any risks associated with Automated Market Makers?

Yes, impermanent loss and potential vulnerabilities in smart contracts are risks to consider when using AMMs.

Can anyone provide liquidity to an Automated Market Maker?

Yes, anyone can contribute assets to a liquidity pool on an AMM platform.

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blog author description

Sarath Shyamson

Sarath Shyamson is the customer success person at BlockSurvey and also heads the outreach. He enjoys volunteering for the church choir.

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