Written By
Shivam Sharma
Scribe

What are Automated Market Makers?

February 10, 2022

Automated market makers (AMMs) are permissionless, fully automated decentralized exchanges that allow users to trade digital assets using liquidity pools, instead of a traditional market of buyers and sellers.

Traditionally, buyers and sellers trade on centralized exchanges (think Stock Exchanges) by placing buy and sell orders which get fulfilled through an order book that is then used to match the prices and execute trade.

Imagine that a user places a buy order at $50 dollars for one stock. When other users find a listed price of $50 to be acceptable, they place a sell order that gets executed as a trade, which establishes $50 as the stock’s market price. This price action is determined by the demand or supply of that stock on the exchange. Most assets rely on this traditional market structure, which includes an intermediary (in this example, workers at a Stock Exchange), for trading.

Bringing Asset Exchange to Blockchains

Trying to mirror market structures of traditional finance for crypto tokens on the blockchain brings up a couple issues. First, blockchain technology is new, and the interface is still complex, so the number of buyers and sellers are smaller compared to traditional markets. This means it might be difficult to find enough people willing to trade on a regular basis. Second, for tokens with smaller market cap (overall value), a traditional exchange structure would mean that these tokens have low liquidity, resulting in barriers to entry to the financial market

AMMs fixed both of these problems by creating liquidity pools, which aim to ensure a steady supply of liquidity, and thus long term stability for tokens. To create these pools, the liquidity providers are incentivized to supply the pools with assets. The more assets in a pool means more liquidity for the pools. For a more in-depth look at how liquidity pools work, check out our article on the topic.

The Benefits of AMMs

AMMs offer advantages that reflect the values of web3, which traditional exchanges cannot replicate. Here are just a few of these:

  • Decentralization. The smart contracts that underpin AMMs and DEXs are predefined codes and agreements that help effectively transfer ownership of both the platform and assets to its users. You do not have to entrust your assets to an intermediary to facilitate an exchange.
  • Ownership. Users and liquidity providers interact with DEXs directly from their wallets, retaining full ownership of their assets. It also helps to prevent market manipulation and insider trading that might occur in a centralized setup.

  • Liquidity Availability. Anyone can list an asset on DEXs at anytime, without needing to go through an identity verification process on a centralized system. Incentivizing liquidity providers to supply liquidity means anyone can make an exchange through an AMM at anytime.

  • Security. DEXs and LPs are built on top of blockchains, so they are often similarly distributed across a network of nodes, meaning they are extremely difficult to attack or compromise.

AMMs are still in a nascent stage, so they come with some of their own challenges. Future improvements should lead to lower fees, less friction, and ultimately better access to liquidity for every DeFi user. These will be major strides in realizing the dream of a decentralized financial system, and AMMs were one of the very first strides taken.

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