Exchanges serve as a marketplace for transactions, promoting the adoption of blockchain and cryptocurrencies. However, decentralization, the fundamental tenet of technology, is jeopardized by third-party involvement. Decentralized exchanges (DEXs) appear to counter third-party and centralized exchange participation.

DeFi allows complete decentralized trading by completing trades on-chain, unlike centralized exchanges, which adopt the order book model to provide liquidity. However, an improved method to the order book model is the Automated Market Maker (AMM) introduction.

What is an Automated Market Maker?

Automated market makers (AMM) are protocols that automate and govern the liquidity provision process. AMMs use liquidity pools in a place of a traditional market of buyers and sellers to enable the automatic and unrestricted trading of digital assets. AMM is a DEX protocol in which a mathematical formula determines prices.

Instead of using an order book like traditional exchanges, asset prices on DEX are determined by a pricing algorithm. Smart contracts in AMM-based DEX leverage on liquidity pools. A liquidity pool is a smart contract held within a community-driven pool of various paired tokens. Liquidity pools are pre-funded asset pools that play an essential role in the operation of AMM-based DEXs. AMMs do not require counterparties to execute trades because such transactions take place through a pool of various paired tokens.

AMMs were in use long before cryptocurrency became widely accepted, but because of their vital role in the decentralized finance environment, they are now mostly linked with cryptocurrency. They produce opportunities for liquidity yields without requiring a significant net worth.

How does AMM work?

AMM was adopted in DeFi to solve the order book model of a centralized exchange. As a result, the primary goal is to guarantee that users can always trade cryptocurrency, even without counterparties with matching offers. Because of this, AMMs do not rely on order books despite having trading pairs. Instead, they use smart contracts to manage unique crypto asset pools created to supply the liquidity required to support fluid trading.

AMMs provide greater flexibility for trading in token pairs as; they allow on-chain trading to be carried out by focusing on the interaction between peers and contracts. There is no buyer at the other end of the trade, only a smart contract algorithm. So, for example, in the case of peer-to-peer (P2P) trading, where a buyer trades with a seller, you have peer-to-contract trading (P2C), where the buyer/seller trades with a smart contract. Since all trading is P2C, there is no need for other traders to act as counterparties or a central authority providing liquidity.

Consequently, the AMM protocol pools liquidity into the smart contract to define the price of a digital asset. This means AMM requires liquidity providers and pools to operate. A liquidity pool in the smart contract contains at least two different tokens in an equal ratio.

So, for example, if you want to deposit $1000 of your asset into a liquidity pool, you must do so in pairs, such as ETH/DAI. This is because the pool requires an equal amount of ETH and DAI ($500 each). As a result, Users provide tokens to liquidity pools, and AMMs use predetermined mathematical formulas to ensure that the ratio of assets in liquidity pools remains as balanced as possible and to remove inconsistencies in the pricing of pooled assets.

However, different modifications to this mathematical formula may be made to optimize the pool for various goals and to more effectively support token swaps between multiple types.

Constant Product Formula

AMMs price assets using a constant product formula, which states:

x * y = k

Where x and y are the value of the assets deposited in the liquidity pool, and k is a fixed constant value. In essence, the formula ensures that the pool's total liquidity never changes and facilitates smart contracts to optimize the price ratio between the two assets.

The constant product formula determines a range of prices for two tokens based on the quantity of each readily available token (liquidity). To keep the value of product K constant, the token supply of Y must fall as the supply of token X rises, and vice versa. To understand this, let's use the ETH/DAI pair earlier used. If an AMM has ETH and DAI in its liquidity pool, the price of ETH will rise each time ETH is purchased by traders because there will be less ETH in the pool before the purchase. Similarly, as more DAI is used to purchase ETH, the price of DAI in the pool will fall. When DAI is purchased, the price rises as the pool's total value falls. However, the pool maintains a constant balance such that the combined value of ETH and DAI in the pool will never differ.

Therefore, when a massive amount of assets are deposited, and a large order is placed, a significant discrepancy can appear between the asset's price in the pool and its market price. The disparity in the price in the pool and the market price would thereby cause an arbitrage opportunity for traders to leverage. As a result, arbitrage traders for AMMs are financially motivated to locate assets that are trading at discounts in liquidity pools and purchase them up until the asset's price recovers to its market price.

Advantages of AMM

Privacy and Anonymity

The information about liquidity providers depositing their assets in the pool is not stored on a central server, reducing the possibility of data theft or unauthorized access by a third party. As a result, users do not need registration and Know Your Customer (KYC) processes. In addition, because all transactions are encrypted, and user identities are restricted to their wallet numbers, AMM liquidity providers remain anonymous.

Decentralization

A centralized authority does not hold the assets of the liquidity providers. The predefined agreements that run on smart contract codes execute each asset according to the protocol. The protocol is fully decentralized because no counterparts or third parties are involved.

Token Availability

As long as there is supply and demand, tokens not listed on centralized exchanges can still be freely traded on AMM DEX-based protocol. This implies that new projects will likely list on these AMM-based exchanges before centralized exchanges since DEX can list any token created on the blockchain upon which they are built.

Security and Protection

DEXs operate on the same network of interconnected computers as a blockchain network. As a result, they are well-protected against hacking or computer attacks that could jeopardize the security of user funds. Furthermore, hackers can only interact with liquidity pools on a trading platform, not users who interact with the exchange.

Risks Associated with AMM

Liquidity Risk

Liquidity is an exchange platform's most important aspect, resulting in low spreads. Unfortunately, because a DEX lacks manipulation capacity, it typically has little liquidity, resulting in significant slippage and a bad user experience.

Smart Contract Risk

Smart contracts execute the assets in the liquidity pool, and they are available on public blockchains, and anyone can inspect their code. As a result, exploitable bugs in smart contracts may evade thorough audits and code reviews. As a result, auditors may find it difficult to predict possible new exploits that could cost liquidity providers their tokens.

Slower Transaction Time

Transactions take time to process because they must be communicated to the blockchain network for miners to confirm before they can be processed. As a result, traders are more likely to experience price slippage when a transaction fails to exchange because the asset value has changed.

The Takeaway

One of the most significant DeFi innovations is automated market makers. The protocol does not entrust the management of asset custodians or intermediaries; instead, they are managed by smart contracts in the liquidity pool. This means that DEXs are self-contained decentralized applications (dApps) that enable traders to trade without handing over control of their funds. Decentralized exchanges would be impossible without functioning AMMs, and crypto traders would be forced to rely on custodial exchanges.

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