Thousands of people use decentralized exchanges (DEX) for the first time daily. This is due to the growing rate of decentralized finance (DeFi).
DeFi is changing how we buy and sell. Even though knowledge of DeFi is common, not many people know how they function. DeFi protocols function in one way:by using an automated market maker (AMM).
Many people are unfamiliar with AMMs, but they are essential in providing liquidity on any DEX. So, what exactly is an automated market maker, how does it work and why is it vital?
Understanding a Market Maker
What is a Market Maker? It is important to understand who or what a market maker is first before understanding what an Automated Market Maker is.
Market Makers: The parties that provide liquidity between buyers and sellers in traditional financial markets. The image below gives further explanation.
Liquidity: "Liquidity describes your ability to exchange an asset for cash. "
The easier it is to convert an asset into cash, the more liquid it is. And cash is generally considered the most liquid asset. Cash in a bank account or credit union account can be accessed quickly and easily, via a bank transfer or an ATM withdrawal."
~Forbes
For example, selling crypto at a fair market price is possible due to liquidity.
What are Automated Market Makers
Automated Market Maker (AMM: "A type of crypto deentralized exchange that allows for trading without order books. It uses cryptocurrency asset pools to enable trading."
~Limechain
AMM mechanism allows buy and sell orders on a DEX. AMMs differ from normal market makers because they use self-executing computer programs to function. These computer programs are known as smart contracts.
There is no use for another participant when making a trade with AMMs. However, AMM and its algorithm enable buyers and sellers to trade directly. The algorithm determines the price of a cryptocurrency you want to trade. In the altcoin market, tokens usually have low liquidity. As such, the algorithm becomes vital.
AMMs automate the transaction process. However, it is still important to have liquidity providers which help AMMs to operate.
AMMs differ from traditional exchanges in that;
They incentivize users in yield farming to deposit crypto assets in liquidity pools.
Use the algorithm x*y=k, providing everyone trading with the pool a constant price.
Automatically swap assets between traders and liquidity pools by using smart contracts.
Liquidity Pools and Liquidity Providers
AMMs function with the help of liquidity pools and liquidity providers. Liquidity providers are people who provide their funds to these pools.
On AMM exchanges, users trade against a pool of tokens instead of trading between buyers and sellers.
Users are the suppliers of the tokens in a liquidity pool. On the other hand, a mathematical formula determines the price of the tokens in the pool.
How do AMMs work?
AMMs use pre-programed mathematical equations that adjust prices based on supply order to make sure the ratio of assets in a liquidity pool is balanced.
The formula or the equation is dependent on the DeFi protocol. Simple ones like Uniswap use the equation of x*y=k.
In the equation;
x= the quantity of one token in the liquidity pool
y= the quantity of the other token
k= fixed constant
Other AMMs may use more advanced formulas.
While using the DeFi protocol with an AMM, it comes in handy as it has no requirements. Anyone with a crypto wallet can trade digital assets on the DeFi exchange run by AMMs.
As such, it is easier for specific blockchain projects to launch new cryptocurrencies.
Closing Thoughts
Automated markets are a significant innovation in decentralized finance. Without their operation, DEXs would not be possible, and traders in the crypto space would still rely on intermediaries and central exchanges.
It is, however, essential to note that AMMs are still in their infancy. Some are limited in features, while more advanced ones are yet to catch on with the rest of the crypto world.
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