Automated Market Makers (AMMs) have emerged as an important element of decentralized exchanges, as users seek a way to exchange their tokens without having to deal with a custodial authority.
AMMs enables users to exchange their cryptocurrencies for others without entrusting their tokens to a centralized exchange.
What is an Automated Market Maker?
An AMM is a type of decentralized exchange that exchanges tokens through liquidity pools. Peer-to-peer (P2P) exchange is an example of a decentralized exchange. When it comes to swapping tokens, decentralized exchanges are often confronted with liquidity concerns. A potential buyer, for example, must wait for a potential seller to place an order before the swap can take place on a peer-to-peer (P2P) decentralized exchange. This may take some time, defeating the purpose of instantaneous token exchange.
AMMs are resolving challenges caused by low liquidity levels. They enable permissionless and automatic token switching via liquidity pools rather than traditional means of exchange.
This type of crypto exchange involves a transaction between a person and a liquidity pool. It is a peer-to-contract transaction in which participants exchange tokens with a pool and pay gas fees for transactions.
Typically, liquidity providers supply tokens to liquidity pools (LPs). Anyone can choose to be a liquidity provider as long as the pool is open to the public. Liquidity providers are compensated with gas fees, a new governance token, or both.
What is a Liquidity Pool?
AMMs operate with liquidity pools. Liquidity pools can be regarded as a reservoir of tokens that users can trade against in a decentralized manner. Pools are often open to the public, allowing anyone to inject liquidity, although some are designed to be private. Balancer, for example, provides flexible options for developers of liquidity pools.
Balancer is an example of an Automated Market Maker with liquidity pools that are regulated by a pre-established algorithmic formula. Typically, this defines the value of tokens in the exchange.
Balancer has a variety of liquidity pools, including public, private, and smart pools.
Anyone can participate in public pools to provide liquidity and earn profits. Private pools are designed for a limited number of liquidity providers, while smart pools are a hybrid of public and private pools.
Smart pools incorporate flexibility into the parameters guiding the pools while permitting any user to inject liquidity.
Advantages of an AMM
AMMs provide numerous benefits to the decentralized financial sector, which will be discussed further below.
• No Know Your Customer (KYC) Process
AMMs such as UniSwap and Pancakeswap can be used without requiring the user to go through any Know Your Customer (KYC) procedures. When signing up on a crypto exchange, potential traders must fill out their information, which may involve uploading their identity cards and proof of residence documents.
When using UniSwap, all the user has to do is connect their wallet to the AMM and swap their tokens. It is not necessary to register or upload any documents.
• Improved Liquidity
When the concept of decentralized exchange was developed, liquidity became a critical issue because individuals found it impossible to instantly swap their tokens for another, which was the norm in centralized exchanges. AMM addresses the previously stated difficulties by allowing users to instantly swap tokens without the requirement for custodial authorities.
• Income Stream
AMMs provide a revenue stream for liquidity providers. Injecting liquidity into pools grants users access to a percentage of transaction fees, new governance tokens, or both. The incentives provided to liquidity providers may differ depending on the AMM. New AMMs typically offer higher returns than older ones. For example, when Sushiswap first launched, it employed the vampire attack to lure liquidity providers from UniSwap to its platform.
• Reduced Price Fluctuation
Traders can deal with reduced slippage or price fluctuation due to the increased liquidity provided by the pools in an AMM. It makes token swapping much easier and more cost-effective for traders.
• Swift Token Swaps
The regular decentralized exchange may have to deal with slower users, especially if it is a peer-to-peer trading platform. This is because a potential buyer must wait for a seller to place an order before a transaction can occur. AMMs enable traders to trade against smart contracts, increasing the speed of token swaps.
Instead of a centralized entity, traders interact with the smart contract. The trader is not required to hold their tokens on a centralized account before swapping. Their wallet interacts with the smart contract in real-time and instantly exchanges tokens. Throughout the process, users retain complete custody of their cryptocurrency. This means that, unlike on a centralized crypto exchange, traders do not have to worry about their tokens being stolen during a hack.
Disadvantages of AMMs
• Security Risks
Cyber attacks against liquidity pools are common, especially when loopholes or vulnerabilities in the pool architecture are discovered. There have been multiple reports of liquidity providers losing their assets due to the depletion of pool tokens. In some cases, outsiders may be responsible, while in others, the development team may be the culprits.
Chef Nomi, the developer of Sushiswap, for example, siphoned $14 million in an exit scam but ultimately refunded the money and apologized to members of the community.
• Liquidity Issues
Because not all AMM’s liquidity pools are as large as UniSwap’s, their operations may suffer.
Common Examples of AMMs
Over time, new AMMs emerge to address issues that older solutions may have overlooked. Below are some examples of Automated Market Makers. As always, do your due diligence before using any of them.
Balancer is an innovative AMM that offers flexible options to users, based on what they intend to achieve with the pool. It has several liquidity options such as public or shared pools, private pools, and smart pools.
The public pools available on Balancer are the same as those found in other AMMs. It enables anyone to inject liquidity while also earning rewards. The main distinction between Balancer’s public liquidity pools and others is that liquidity providers can deposit any combination of up to eight different tokens, while the others may only permit up to two tokens.
The parameters that govern public pools are fixed and cannot be altered once they have been finalized. This means that parameters such as the type of tokens added to the pool and the ratio cannot be altered.
Private pools are designed to be extremely flexible, allowing users to change the parameters of the pools. Usually, this type of pool is funded by a single individual or a group of people, and it is not open to the public. This means that not everyone is allowed to inject liquidity into the pool. Only the owner of the pool is permitted to provide liquidity.
Smart pools, on the other hand, are a hybrid of public and private pools. In this case, the pool’s governing parameters are flexible, and anyone can provide liquidity. Unlike in a public pool, factors such as swap fees, tokens, pool weight, liquidity pool restrictions, and much more can be changed over time.
UniSwap is regarded as one of the first AMMs in existence, having been established on November 2, 2018. It has grown to be one of the most popular Automated Market Makers, with the feature that allows anyone to create a pool on the platform. Users can also provide liquidity on any pool they want.
It enables the decentralized exchange of ERC20 tokens, allowing users to exchange their ETH for any ERC20 token and vice versa.
Sushiswap is a fork of UniSwap established in 2020 by a person or group of individuals known as Chef Nomi. It launched a vampire attack earlier in its development, aiming to induce liquidity providers to move their liquidity from UniSwap to Sushiswap. They provided liquidity providers with SUSHI, their native token, for injecting liquidity into various pools.
It performs functions similar to those provided by UniSwap.
- AMMs are a type of decentralized exchange.
- AMMs work with liquidity pools.
- Liquidity providers are rewarded for injecting liquidity into pools. The rewards can come as a share of transaction fees, governance tokens, or both.
- There are different examples of liquidity pools such as UniSwap and Balancer.
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