Automated Market Makers (AMMs) are important in terms of enabling easy transactions through automatic, permissionless transactions of digital assets in the decentralized finance (DeFi) sector. Cryptocurrency trading in AMMS is done with the help of smart contracts that facilitate trading, provide liquidity, and enable price discovery in the decentralized marketplace. AMMS leverages blockchain technology for its day-to-day transactions. Unlike traditional markets, AMMs leverage liquidity from the liquidity pools rather than relying on buyers and sellers.
This article is a beginner’s guide to everything about Automated Market Makers (AMMs).
Why are Automated Market Makers (AMMs) Important?
Automated Market Makers (AMMs) are important in the realm of decentralized finance. It outlines the key changes that mark the shift from traditional finance to decentralized finance (DeFi). The AMMs are important in several respects.
- Accessibility: AMMs are significant in the DeFi market space due to their highly accessible nature. As the DeFi marketspace is connected to the internet, AMM trading is accessible at all times.
- Transparency: The transactions on AMM are highly transparent as each transaction is recorded on the blockchain.
- Interoperability: In the AMM model different components involved can seamlessly interact with each other.
- Programmability: AMMs are controlled by smart contracts that are programmable according to the various use cases.
- Financial Inclusion: AMMs are part of DeFi’s mission of financial inclusion.
How Do Automated Market Makers (AMMs) Work?
The prices of the tokens in an AMM are determined by the liquidity pool of the token. The price is calculated based on the ratio of the tokens in the liquidity pool. The formula used for calculating the price is (x * y = k), where x and y are the quantities of two tokens in the pool, and k is a constant. The formula means that when the quantity of a token decreases, the quantity of the corresponding token should increase to maintain the constant value. This model enables tweaking the price of tokens based on their demand and supply and gives importance to liquidity provision. When a user wants to trade a token, they can swap it for another token directly through the AMM.
AMM model ensures that there is continuous liquidity for a particular token. Even if the token is less popular, it will have increased liquidity in an AMM compared to that of traditional markets. The liquidity providers of AMMs are adequately incentivized.
What are the Four Types Of Automated Market Makers (AMMs)?
The Automated Market Makers (AMMs) can be broadly divided into four major types.
- Constant Product AMMs
- Constant Sum AMMs
- Hybrid Models
- Concentrated Liquidity AMMs
Constant-product AMMs maintain a constant product of the assets in the liquidity pool, as per the formula x * y = k. This type of AMM assures that the price of an asset is automatically adjusted according to the liquidity available. This model ensures the simplicity of the transaction while stressing liquidity.
Constant-sum AMMs are AMM models in which the sum of the quantities of an asset should be constant. This model follows the formula x + y = k. In this model, the asset price is not changed as long as the total quantity of the assets remains the same, preventing price slippage.
Hybrid Models combine traditional automated market makers (AMMs) and order book systems. Curve Finance and Balancer are examples of Hybrid AMMs.
Concentrated Liquidity AMMs allow liquidity providers to invest their capital within specific price ranges. This model ensures that capital efficiency is enhanced and potential returns are collected. This model provides flexibility to the liquidity providers in terms of choosing price ranges. The Concentrated Liquidity AMM model is used in Uniswap V3 exchange.
The Bottom Line
Automated Market Makers (AMMs) are beneficial to all users of decentralized finance in terms of the accessibility they provide at lower costs. They are also seminal in determining and maintaining the liquidity of a particular token. The provision for permissionless trading while ensuring reduced counterparty risk makes AMMs a sought-after model in decentralized finance trading. Many AMMs such as Uniswap, Sushiswap, Balancer, and Pancakeswap are adequately serving the industry and investors.
Automated Market Makers (AMMs) are seminal in determining the future of layer 2 solutions and the decentralized finance sector as a whole.
