What Is an Automated Market Maker?

Ever wondered how swiftly your buy or sell orders get processed on stock exchanges. It is as if there is always someone ready to buy the exact same amount that you are thinking of selling. Not really! In reality, there are “forces” behind with deep pockets who ensure the market remains highly liquid and trades happen with ease. That is the story of traditional markets. But what about decentralized crypto markets? Though it is hard to find one entity with “deep pockets,” there are several other ways to ensure liquidity. This article talks about one such mechanism – Automated Market Maker or AMM.

Who Are These “Market Makers”?

In the quintessential traditional stock markets, large banks or financial institutions typically are the market makers. They help ensure there is enough volume of securities available for investors to buy or sell seamlessly. Without market makers, finding buyers and sellers with matching orders becomes an arduous job and makes trading an overcomplicated and non-lucrative process. 

How does it work? – If I want to buy 100 shares of company A, there needs to be someone on the other end who has 100 shares of the same firm ready to sell. Else, the transaction process is impeded. Here is where market makers come to play. They usually hold an inventory of stocks they make a market in – in this case, a big bank has thousands of shares of company A at their disposal, of which they are ready to sell 100 shares at a moment’s notice. So my trade gets executed instantaneously.

In summary, market makers are high volume traders who, in a literal sense, “make a market” by always being ready to buy or sell.

Are There Market Makers in DeFi?

Contrary to the traditional markets, there are no big banks waiting to add liquidity in the decentralized finance (DeFi) markets. In addition to adhering to the fundamental tenet of having no central player – in this case, a big bank with large volumes to trade, the abstruse nature of the DeFi ecosystem dissuades conventional institutions to invest heavily in this space. So how do we make these arcane DeFi markets attractive for mass adoption? Enter Automated Market Maker or AMM. 

AMMs are unique to DeFi, where a piece of code, known as smart contracts, in conjunction with pre-funded liquidity pools, act as market makers. Users trade with “smart contracts” instead of banks or brokers. These regular users are also the liquidity providers. 

How? On a DeFi platform, there is a liquidity pool for an asset pair. Asset prices are determined in real-time by using oracles. One way to add liquidity is for users to deposit the equivalent value of each asset in a proportional ratio. If one of token A is worth four of token B, then the liquidity pool for the A-B pair needs to have at least one token A and four token Bs. If any user tries to deposit more of one asset than another, the transaction is invalidated. The idea is to maintain a constant balance of value between the two tokens in the pool. This approach is one of the many ways that exchanges use to add liquidity. Each AMM in the DeFi ecosystem – Uniswap, Curve, Balancer – follow their own mechanisms to add liquidity.

What is it in there for these liquidity providers? Users adding the much needed “liquidity” to the platform are called liquidity providers. They are usually compensated by means of transaction fees or rewards. When traders buy or sell the tokens in the liquidity pool, they will pay a fee for their transactions to get processed. These fees are apportioned among everyone who provided the liquidity in amounts commensurate with their contribution. Meanwhile, some pools offer rewards, typically the native currency of the DeFi platform, as incentives to the market makers. These yields are often sufficient to drive the interest among the users to become liquidity providers.

What Value Does Automated Market Maker Provide?

At the time of writing, the total value locked (TVL) in DeFi protocols was $83.49 billion, in which AMMs play a vital role. Some estimates suggest AMMs hold over 90% of the market share for decentralized exchanges. The trend indicates that there are significant benefits for platforms to use Automated Market Makers.

To begin with, AMMs keep light on in the decentralized finance network 24 X7, and the traders don’t have to worry about liquidity getting depleted. Furthermore, AMMs allow the DeFi marketplaces to function in a decentralized and permissionless manner, thereby adhering to the core tenets of the blockchain ecosystem. Also, in a fledgling DeFi ecosystem, getting banks or brokers with deep pockets is challenging. Here is where AMM plays a significant role in adding much needed liquidity.

Are There Any Risks?

While engaging with the DeFi markets comes with certain risks, automated market making has its own drawbacks. First, if the liquidity pools are not sufficiently funded, wealthy investors looking for a big buy would get disappointed. Furthermore, if the token supply is less and the demand more, traders will have to pay a premium, sometimes higher than the market price, for their orders to get through. This risk is called Slippage.

Another peril to be aware of is impermanent loss. One of the assets in the pair is more volatile than the other; that asset might get traded/bought less than its more stable partner. In this case, there is an imbalance in the amount of each token. The price of the asset rises while the amount held reduces, the liquidity provider suffers an impermanent loss. The loss is although not permanent because trades on the exchange can balance the pair’s ratio.

In conclusion, albeit some concerns, Automated Market Makers have become a reliable source of liquidity in the growing decentralized finance markets, and as of now, show no signs of abating.