Demystifying AMM: The Key to Decentralized Finance’s Liquidity Revolution

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Liquidity is a critical concern in any market, including financial markets and commodities outside of traditional exchanges, attracting attention from investors and businesses alike. In recent years, within the cryptocurrency market, developers have created numerous automated market maker (AMM) platforms, known as AMM DEX. So, what exactly is an AMM DEX? Let’s delve into the intricacies of AMM with Tonraffles!

What is AMM

AMM stands for Automated Market Maker. In the cryptocurrency market, AMM refers to a tool that automatically supports and connects cryptocurrency traders in a decentralized manner or creates a peer-to-peer (P2P) market to mitigate limitations and inefficiencies.

AMM protocols are commonly applied in decentralized exchanges (DEXs) such as Uniswap, 1inch, SushiSwap, Trader Joe, which are built on various blockchain ecosystems but utilize the AMM protocol for construction and development.

AMM emerged as the cryptocurrency industry expanded its influence, and centralized exchanges began to reveal limitations such as security issues, liquidity concerns, and more. The emergence of AMM marked a milestone in addressing these drawbacks of traditional centralized exchanges.

The operating mechanism of AMM

The mechanism of Automated Market Makers (AMMs) relies on protocols that employ mathematical formulas to price assets rather than depending on the number of orders on centralized exchanges, where prices can be manipulated by market makers.

In centralized exchanges, trade orders are not pre-set and are only matched when someone agrees to buy/sell at a certain price. In contrast, on AMM platforms, trade orders are matched almost instantly thanks to a special algorithm that calculates a base price and adjusts the price based on actual demand.

Specifically, UniSwap uses the formula X * Y = k, where X and Y represent the first and second liquidity pools respectively, and k is the constant product of liquidity, which remains unchanged.

Certainly! In an Automated Market Maker (AMM), there are no buy or sell orders; it’s simply a matter of depositing one type of token into a pool containing two types of cryptocurrencies and withdrawing another type of token. Withdrawing one type of cryptocurrency alters the ratio between them, consequently changing their prices.

For instance, in a pool with 1000 USDT and 1000 DAI, if you deposit 100 DAI and wish to withdraw USDT, the ratio between the two tokens in the pool becomes approximately 900 USDT and 1100 DAI. So, the next time you want to withdraw, you’ll need to deposit 110 DAI to withdraw 90 USDT. Clearly, the price of USDT has increased. Now you understand, right?

However, it’s essential to remember that this adjustment occurs according to an algorithm, so prices could theoretically rise indefinitely if you deliberately attempt to withdraw one type of cryptocurrency entirely from the pool.

Liquidity Pool

For an AMM or DEX to operate smoothly, it needs to have a sufficiently large and stable liquidity pool. The liquidity pool, also known as the liquidity pool, plays a crucial role in supporting and stabilizing asset exchanges, making it essential for an AMM and DEX. This means there must be liquidity providers who deposit both types of cryptocurrencies into the pool simultaneously for users to exchange when needed. In return, they receive a certain fee when transactions occur, typically around 0.3%. This fee can accumulate significantly over time, breaking the profit monopoly of exchanges as users also benefit from transaction fees.

The operation of liquidity pools is relatively straightforward. Liquidity providers deposit their tokens into the protocol to earn rewards. Then, anyone can use those cryptocurrencies depending on the protocol’s mechanism.

Let’s take the example of Uniswap, the most popular DEX in the DeFi industry, to understand how Uniswap’s liquidity pools work.

On Uniswap, liquidity providers deposit a pair of assets, such as the DAI/ETH pair. The 50/50 ratio is set by the protocol, so when users add 1 ETH to this pair, they must provide the corresponding value in DAI.

To ensure perpetual liquidity, Uniswap utilizes an automated market-making formula.

This means that during the exchange process, the amount paid depends on the ratio between the two tokens in the pool (in our case, DAI/ETH).

As a result, placing larger orders relative to the pool size results in worse exchange rates as the ratio moves along the curve.

This phenomenon is known as slippage.

Other protocols may use different formulas, but the common goal is to provide users with the most stable trading environment.

• Liquidity Pools: The Core Mechanism Driving DeFi

Advantages and Challenges of AMM

Advantages of AMM compared to traditional exchanges:

1. High security: You don’t need to provide any personal information to use automated liquidity pools, mitigating risks of data breaches.
2. Automated trading: Prices are determined by algorithms and executed automatically by smart contracts, eliminating concerns about order mismatches or long waiting times.
3. Low slippage: Transaction prices between placing an order and order execution experience minimal changes, except for low-liquidity tokens.
4. High transparency: All transaction processes are recorded on the blockchain, allowing users to access transaction information at any time.

Disadvantages of AMM compared to traditional exchanges:

1. Token impersonation: Creating a liquidity pool on AMM is quick and easy, allowing malicious actors to create fake token pairs. These tokens may mimic genuine tokens from logos to names, with the only differentiator being the smart contract.
2. High transaction fees: Uniswap, the most widely used automated liquidity platform, operates on the Ethereum blockchain, known for high gas fees and frequent transaction congestion.
3. Impermanent loss: This loss occurs when comparing holding tokens in a wallet versus contributing them to a pool. It happens when the token’s value in the liquidity pool differs from its value outside the pool. Contributors experience losses when withdrawing tokens from a pool where the token’s value has decreased.
4. Slippage: Due to the unique operation of Automated Market Makers, while they have mitigated liquidity shortages, slippage is still an issue. The more of a cryptocurrency you withdraw, the higher the price increases.

FAQ AMM