With the ability to eliminate an intermediary between parties engaged in a transaction, decentralized financial markets are growing in popularity. One of the hidden gems of this growing popularity is the Automated Market Maker (AMM) protocol that is included in these financial markets.

In this article, we’ll learn about what are AMM and its role in DeFi.

What is a market maker?

Before delving into the topic of AMMs, it’s crucial to understand how conventional market makers work. Market makers are dependable parties who provide liquidity among buyers and sellers in a typical financial market, such as the stock market.

Centralized Crypto exchanges have connected buyers and sellers throughout the majority of history. However, slippage (or when an asset’s price fluctuates before the deal is completed) can happen if there needs to be more liquidity on the market to match buy and sell orders instantly.

Because of this, additional liquidity for centralized exchanges is provided by organizations like banks and individual traders and funds. These market makers construct numerous bid-ask orders to guarantee that counterparties are accessible for each deal.

Why is liquidity so important in the Crypto market?

It is simple to sell highly liquid Crypto for a reasonable market price. A non-liquid asset, however, cannot be sold without a great deal of effort or a loss in value. That is why market makers are crucial in the financial markets since you might only be able to achieve the price you initially desired if there is enough liquidity.

What is an Automated Market Maker (AMM)?

A digital instrument or protocol called an automated market maker enables trustless Crypto transactions or those that take place without a third party. Although not all Crypto exchanges employ them, all Decentralized Crypto Exchanges do (DEXs). Though the entire concept of Crypto is mainly based on decentralization, many major Crypto exchanges today do not employ a decentralized approach, which might be unsettling to some.

So, an automated market maker can be your first point of contact if you wish to use a completely decentralized exchange.

Uniswap, a decentralized exchange running on the Ethereum blockchain, was the first to provide an automated market maker successfully. AMMs have grown much more prevalent in the DeFi space since their introduction in 2018.

Outside of the DeFi sector, an automated market maker is nowhere to be found. In essence, they serve as an alternative to the standard order books used by conventional exchanges. AMMs step in and appropriately price the assets rather than one user providing a price to acquire an asset from another. So how do they function?

How does AMM work?

Before we jump onto understanding the working of AMMs, we need to get a better understanding of the common terms, i.e., liquidity pools and liquidity providers.

Liquidity Pools And Liquidity Providers

Automated market makers require liquidity providers and pools to operate. A liquidity pool is basically a Crypto reserve that is used to ease future transactions. Liquidity providers are those who provide their money to these pools.

Similar to how Forex traders buy and sell currency pairs, liquidity pools usually accept just two Cryptos. For instance, a trader can use an AMM to sell Bitcoin (BTC) and purchase Ether (ETH) from a BTC/ETH liquidity pool, and vice versa.

Some AMMs and liquidity pools handle several Cryptos simultaneously. Your AMM and decentralized exchange will determine this.

How does AMM work?

AMMs adjust the prices depending on supply to maintain a balanced ratio of assets in any liquidity pool by using pre-programmed mathematical formulae.

For instance, a trader can purchase ETH by offering to sell BTC in a liquidity pool for ETH/BTC. The price of ETH will automatically increase to make up for a reduction in the amount of remaining supply in the pool. On the other side, prices will decrease as a result of the increased supply since there are more BTC in the liquidity pool. When ETH is used to buy BTC instead of the other way around, ETH’s value decreases while BTC’s value increases.

The particular DeFi protocol in issue will determine the precise formula or equation. Some, like Uniswap, employ a comparatively straightforward formula x*y=k. The quantities of one token in the liquidity pool, x, the other token, y, and a fixed constant, k, are used in this calculation.

Different AMMs could employ more complex mathematical formulae.

Bottom line

In the DeFi space, automated market makers are commonplace. They make it possible for anyone to construct marketplaces quickly and effectively. They may have certain drawbacks compared to order book exchanges, but overall, the innovation they provide to Crypto is priceless.

AMMs are only starting out. The AMMs we are familiar with and use today, such as Uniswap and PancakeSwap, are lovely in appearance but have limited functions. Future AMM designs are likely to be significantly more creative. Every DeFi user should benefit from lower fees, less friction, and improved liquidity as a result of this.