What is an Automated Market Maker? An Automated Market Maker (AMM) is an important term that we're seeing become more prevalent in cryptocurrency trading. Let's take a closer look.
What is an Automated Market Maker?
An automated market maker (AMM) is a kind of decentralized exchange (DEX) protocol that values assets using a formula. Assets are valued using a pricing algorithm rather than an order book like a traditional exchange.
This formula can vary with each protocol. For example, Uniswap uses x * y = k, where x is the amount of one token in the liquidity pool, and y is the amount of the other. As k is a fixed constant in this calculation, the pool's overall liquidity must always remain constant. For the particular use cases they focus on, other AMMs will employ other formulas. The fact that they all use algorithms to set their rates, though, is what unites them all.
Traditional market making usually works with firms with vast resources and complex strategies. Market makers help you get a good price and tight bid-ask spread on an order book exchange like Binance. Automated market makers decentralize this process and let essentially anyone create a market on a blockchain.
How Does It Work?
There are trading pairs in an AMM, such as ETH/DAI, and it functions similarly to an order book exchange. However, you don't need to have a counterparty (another trader) on the other side to make a trade. In its place, a smart contract that you interact with "makes" the market for you.
Trades take place directly between user wallets on a decentralized exchange like Binance DEX. On the Binance DEX, if you sell BNB for BUSD, there is a buyer of BNB using BUSD on the other side of the exchange. This transaction can be described as peer-to-peer (P2P).
AMMs, on the other hand, might be thought of as peer-to-contract (P2C). Since trades take place between users and contracts, counterparties in the traditional sense are not required. Since there's no order book, there are also no order types on an AMM. What price you get for an asset you want to buy or sell is determined by formula instead. Although it's worth noting that some future AMM designs may counteract this limitation.
So there's no need for partners, but someone still has to create the market, right? Correct. The liquidity in the smart contract still has to be provided by users called liquidity providers (LPs).
What is an Automated Market Maker? How Does It Work? - Hopefully, this article can help you to get some knowledge.
