Automated Market Makers

Automated market maker tokens, or AMM tokens are some of the best performing tokens within the DeFi space within the last year, but what do they represent? In this piece we will discuss automated market makers: What they do, why their tokens are so valuable, and how automated market makers are used in DeFi.

What is an Automated Market Maker

Automated market makers (AMMs) are a crucial component to DeFi, as they help to facilitate the exchange of tokens in a true peer-to-peer fashion. AMMs are components of Decentralized Exchanges, or DEXs, which incentivize users to become liquidity providers in exchange for a portion of the transaction fees and tokens, or both. Simply put, AMMs and DEXs are designed to autonomously eliminate the need for centralized exchanges.

What are Centralized Market Makers

Centralized exchanges can offer a wide range of services, but they mostly serve as a middleman between traders. In a centralized exchange, a trader needs to be matched up with another trader who is looking to buy or sell the exact amount of the same asset that you are looking to buy or sell, for the transaction to occur. The market making functions of a centralized exchange do exactly that. Centralized market makers aim to match users’ orders as quickly as possible.

Liquidity

When the market maker can’t find a suitable match for a buy or sell order, it is because the liquidity of an asset is low. Assets such as Bitcoin and Ethereum have high liquidity because of their high trading volume. On the other hand, many of the brand-new microcap tokens which enter the market tend to have low liquidity, since they are only traded by a small number of people.

How Automated Market Makers Work

Unlike centralized market makers, automated market makers make use of liquidity pools. A liquidity pool is an individual smart contract that contains two deposited cryptocurrencies in AMMs. These smart contracts work similarly to the trading pairs found in centralized orderbooks. For example, a trading pair for ETH/USDT on a centralized exchange, could be represented as a ETH/USDT liquidity pool on a DEX. Those providing liquidity to the ETH/USDT liquidity pool within the AMM, would have to deposit a designated ratio of ETH and USDT into the pool.

Liquidity pools are kept even to eliminate price discrepancies. AMMs use preprogrammed mathematical equations to control the flow within the smart contract. Most AMMs utilize the simple XYK model of pooled liquidity. All this means is that the liquidity pool holds x number of token X, and y number of token Y. X must invariantly equal Y to maintain the constant of K. since K is constant, the AMM determines the ratio of how many of token X and token Y a person can deposit or withdraw to provide liquidity to the pool in an inherently balanced way.

DEXs rely on AMMs to compensate for slippage when exchanging tokens. The AMM essentially smooths out the swap between different tokens as their values constantly experience slight fluctuations. Since DEXs cost a small fee to use, some of that fee can go to reimbursing the liquidity pool whenever the value of two tokens in a pair has fluctuated.

Rewards for Providing Liquidity

As DEXs charge fees whenever someone swaps currency through the AMM, the AMM then rewards those who provided liquidity to the pools with some of the fees the user was charged for the service. In certain cases, you can even earn additional tokens, such as governance tokens – which can grant you voting privileges regarding changes to the protocol – for staking your crypto in a liquidity pool. AMM tokens have been one of the best performing sectors of tokens within DeFi, and will likely continue doing so as they become more prominent in the world of crypto!

Killer Whale Crypto

CHANGE THE WAY YOU TRADE