What Is AMM?

What Is an AMM? 

What is an AMM? The essence of market making is as old as the world: buy cheaper, sell more expensive. The one who “makes a market” for some asset is engaged in providing a service: he is always ready to act both as a seller if you need to buy, and as a buyer if you need to sell. 

For example, a currency exchanger in the market is pure market-making: you can always buy currency in exchanger and always return it to the same place. And, for example, a food stall in the market is not engaged in market making: it only sells sausage and cheese, but does not buy them from you. The gold buying stall only buys gold from the population, but does not sell gold to the population.

A market maker in the exchange business provides services in the form of sale of a security and its purchase. The market maker can carry out its operations both in the office, i.e. outside the exchange, over-the-counter, and on the exchange, participating in the auction at the same time as a buyer and seller. 

To do this, the market maker puts two limit orders on the exchange: one order to buy, the other to sell.The automated market maker has replaced a system in which all orders were made manually in the order book and analyzed by the exchange staff in search of matches. This approach was severely limited in efficiency and speed. In modern centralized exchanges, it is often the bidders themselves who look through the order book, selecting suitable offers from the list.

For the first time, the AMM DeFi system began to be used on exchanges in the early 90s, and they were intended to increase market liquidity. This was done largely due to increased accusations of "manual" market makers of manipulating the market. Automated market makers have solved most of the problems caused by the human factor, such as price slippage or price detection delays. Later, in the field of cryptocurrencies, AMMs formula began to be actively and commonly used in exchange services on decentralized crypto exchanges. 

How Does AMM Work?

What is AMM? What is AMM crypto meaning? Liquidity providers enter two currencies into the system for the same amount in dollar terms in the so-called pools. From that moment on, the algorithm manages the money.

The pool client makes an application for an exchange at a rate that suits him with a small percentage of admission. It sends one coin and, as soon as there is liquidity in the system on suitable conditions, it receives back the necessary tokens at the AMM internal rate with a commission fee. The situation when the price of an order increases during the search for liquidity or confirmation is called slippage.

When the volume of one of the currencies in the pool begins to decrease, the market maker raises its value and lowers the second. Thus, the overall balance of assets is maintained. There are more complex algorithms that align several pairs of tokens at once.

Liquidity providers can withdraw their investments at any time along with the commission earned. At the same time, the output AMMs crypto assets may not quantitatively coincide with the deposit (one more, the other less), but the total value of the pair will be preserved.

What Platforms Use the AMM Model?

Uniswap. The first AMM DeFi exchange was launched in 2019. It provides an opportunity for everyone to invest in liquidity pools and earn on it in a passive mode. The value of the coins is determined only by the internal smart contract.

Balancer is a project inspired by Uniswap. It has more complex AMM models that manage several currency pairs at once.

Curve platform was launched in 2020. All users can add liquidity, but pools are created exclusively by moderators. The main difference is that only stablecoins are accepted in all pools. Thanks to this, there are many large investors on the site.

Sushiswap. The pools accept ERC20 coins and ETH. All important decisions about the fate of the platform are made by the holders of the native SUSHI token by voting.

Bakeryswap. It is an improved version of Uniswap, launched in 2020. It has a standard AMM model, supporting about three dozen tokens. Liquidity providers, in addition to the exchange fee, receive a reward in the form of the base token of the BAKE site.

Thorchain. One of the few AMMs outside the Ethereum network. The main uniqueness is the ability to trade between blockchains. For deposits of 100 days or more, a floating loss guarantee is offered.

What Is the Purpose of AMMs? 

What is AMM’ purpose? Automated Market Makers are needed in order to eliminate the liquidity problem on decentralized exchanges. The direct providers of liquidity are exchange users who receive their reward for making a transaction, and this liquidity is distributed by automated systems that ensure that there are no problems with manipulating rates, as was the case with manual liquidity providers on Forex exchanges.

What Are Pros and Cons of AMMs? 

Pros 

Strong slippage reduction.

Holding orders for no more than a second.

High speed and low maintenance. 

Great liquidity in various markets.

The other side of the transaction (the seller) does not need to be online.

Smoothing sharp price fluctuations.

Protection against price manipulation (pump, dump, etc.)

Increase in net profit.

Attracting new investors.

Cons 

Multi-currency exposure. Liquidity providers need to invest at least two currencies, one of which will always be less reliable than the other. Risks increase and possible income decreases compared to investing in one asset.

Impermanent losses. Due to the growth of the exchange rate of one token relative to another, the total withdrawal amount may turn out to be less than if the money were simply kept in the wallet. The reason for this is the mechanisms of automatic regulation and the actions of arbitrageurs.

Low return on investment. To minimize slippage as much as possible, you need to invest the largest possible amount, which in the end will still not be fully used.

How Is AMM Used Outside Cryptocurrencies?

Similar principles of work can be seen in Forex, which is a multi-level system of orders for transactions with fiat currencies. Since 90% of traders occupy the lowest level in the system, they need intermediaries. Among them there are so-called dealing centers. They use up-to-date world quotes, but all traders' orders are cooked inside the system itself, without entering the external market. Honest brokers add up all orders for the sale and purchase of each currency, while the difference is displayed in the interbank market. This automatic trading algorithm is called matching.

In the world outside the blockchain, the old principles of market making are mainly used, when transactions are carried out in manual or semi-automatic mode. The problem of low or no liquidity is not so acute here, so new algorithms are not in much demand compared to the DeFi sector.

 

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