What is Automated Market Maker (AMM) in DeFi?
An automated market maker (AMM) is a type of market maker that uses algorithms to automatically price and trade assets in a financial market.
In the cryptocurrency and decentralized finance (DeFi) space, AMMs are used to provide liquidity to trading pairs by creating and selling digital assets in exchange for other digital assets.
AMMs are often used in DeFi protocols to provide liquidity to trading pairs that would otherwise not have enough volume to be traded on a traditional exchange. By using an AMM, traders can buy and sell digital assets without having to worry about finding counter-party to trade with.
How Market Making Works
Typically, market making is a process of matching traders.
That is, finding a buyer for a seller. For example, a trader willing to buy 1 ETH at $1,500 will be matched with a seller willing to sell 1 ETH at the exact price. This is ultimately the principle of market making.
But what happens when there is no match? Liquidity is said to be low when the buyer of 1 ETH cannot be matched with a seller of the same.
Liquidity refers to the scenario where many traders are in the market. In such cases, pairing buyers with sellers is very easy. But in a case of low liquidity, crypto assets are not easily sold because buyers might not be available for the exact amount per time. This is why there are high slippages.
Centralized exchanges (CEX) rely heavily on financial institutions for liquidity. They provide them with enough resources to ensure smooth trading on the exchange.
Once enough resources are available for a CEX, buyers, and sellers can easily be matched. In this case, the financial institutions are responsible for providing liquidity, thus called market makers.
What is an Automated Market Maker (AMM)?
Unlike the system adopted by the centralized exchanges, a DEX, on the other hand eliminates the process of matching pairs.
AMMs typically use a constant product formula to determine the price of an asset, which means that the price of the asset is directly proportional to the amount of liquidity that the AMM provides. This makes AMMs different from traditional market makers, which use a more complex pricing model that takes into account the supply and demand of an asset.
The constant product formula used by AMMs is designed to incentivize market makers to provide liquidity to the market even when there is little or no trading activity. This is because the market maker earns a small amount of interest on the liquidity that they provide.
Advantages of AMMs
The use of AMMs in cryptocurrency and DeFi has been growing in recent years, as they offer a number of advantages over traditional market makers. One of the biggest advantages is that they allow for the decentralization of liquidity provision, which reduces the risk of manipulation and fraud.
Another advantage of AMMs is that they can be used to provide liquidity to markets with low trading volume. This is because the constant product formula means that the market maker will still earn a small amount of interest even when there is little trading activity.
Finally, AMMs are often cheaper to use than traditional market makers, as they do not require the same level of capital. This is because the constant product formula means that the market maker does not need to take into account the supply and demand of an asset when setting the price.