Last updated on March 4th, 2023 at 02:59 am
As you have been digging deeper and deeper into the world of cryptocurrency and decentralized exchanges, many new terms have been popping out at you: automated money makers, Uniswap, token exchange, etc.
This article is going to cover one of the aspects of decentralized exchanges: automated money makers.
Automated market makers are computer algorithms that automatically match orders to buy or sell an asset without the need for a third-party exchange. This system was first popularized by Uniswap, which is a decentralized protocol on Ethereum that allows users to swap cryptocurrency through a liquidity pool that is funded by liquidity providers. Unlike a regular stock trading platform, third-party liaisons are not needed to settle any crypto trades.
In addition, Automated Market Makers’ technology is decentralized, available for trading 24/7/365 and there is no traditional interaction between buyers and sellers.
A liquidity pool is a pool of cryptocurrencies or tokens in the AMM that are crowdsourced and locked in a smart contract. The pool is created by liquidity holders and the pool is used to facilitate trades on a decentralized exchange.
So let’s say, you wanted to trade some crypto and had some other crypto to trade for it. Here is what happens:
You put down the amount of crypto you have in and you get the crypto you want from the pool, slippage amount pending. No intermediaries or liaisons acting as a counterparty. The price is determined, and the order is executed automatically by the AMM.
You can be a liquidity provider – you can earn fees by providing your token supply to the pool and the fees are paid by traders who interact with the pool. In exchange, you get Liquidity Provider tokens that represent the share of the pool you own. Those tokens are ERC-20 in which you can transfer, exchange or even stake.
There are different designs as far as the workings of an AMM, but the constant function AMMs are the most popular. These AMMs are based on constant functions where the combined asset reserves of pairs in the liquidity pools must remain constant.
The following equation is used for constant product in many DeFi exchanges:
X * Y = K
- X – the quantity of asset A
- Y – the quantity of asset B
- K is a constant
The price of asset A relative to asset B is Y/X.
So, if the amount of asset A decreases, the amount of asset B will need to increase in order to maintain the balancing effect of constant K. This will cause the price of asset A to increase and vice versa.
You uh, wanna ELI5, please?
To understand how this works in Explain Like I’m 5 mode, let’s use a BTC/USDT liquidity pool as a case study. Let’s say I want to buy Bitcoin and I have a supply of USDT to trade for it. Therefore, I add the USDT amount of BTC I want to the pool and remove BTC from it.
This causes the amount of Bitcoin in the pool to fall, which, in turn, causes the price of BTC to increase. In contrast, because more USDT has been added to the pool, the price of USDC falls.
However, I need to remember one vital factor: slippage.
Slippage is the difference between the expected price of a trade and the actual execution price of the trade. Slippage can occur during periods of high volatility, such as news about crypto or even major events such as the Ukraine invasion.
Another reason for slippage is that there may not be enough liquidity in the pool. If there is not enough liquidity in the pool you will get less bang for your…crypto.
- Use More Gas
- Trade on a Layer 2 Solution
- Adjust Slippage Tolerance Levels
- Anonymity – All you need is your wallet address. No “Know Your Customer” verification hoops to jump through.
- Possession – Tokens exchanged through AMMs are 100% yours; you can keep them in your wallet. Keeping tokens on centralized exchanges can involve owner approval and don’t forget the old adage: not your keys, not your coins.
- Transparency – All exchanges through AMMs are revealed through the Smart Contract.
- Slippage – as discussed above
- Possible high fees
- Congestion on the Network
Automatic Market Makers are an important part of decentralized finance in which you can trade your cryptocurrencies without the use of the traditional buyer/seller format. In the past 2-3 years, we have witnessed the emergence of many, many decentralized exchanges that are driving the ongoing hype.
While the approach is not flawless, the advancements recorded in the last 12-24 months are indicative of the several possibilities that an automatic market maker can provide in the world of decentralized finance.
Dani Lehmer is the Founder and Head Honcho of Dani Digs In.
She is a Quality Assurance Analyst and blogger whose natural curiosity allows her
to dig in (pun intended) to help people build their businesses and satiate curiosity
in regard to data science, analysis, and crypto.