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Automated Market Maker (AMM) Explained

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Decentralized finance (DeFi) has exploded as well as Ethereum and smart contracts platforms. Yield farming became a new way for token distribution. All in all, the technologies changed the crypto game in 2020. 

Automated market maker protocols like Uniswap or Balancer got its piece of the pie. The popularity of such platforms became enormous not only in terms of the technology itself but in liquidity and trading volumes. How does AMM work, and what is its future? We’re here to give the answers to these questions. 

What Is an Automated Market Maker and How Does It Work?

An automated market maker is a type of decentralized exchange. The fundamental difference is that AMMs use a mathematical formula to calculate the rate, and not an order book (ask and bid orders), as on a traditional crypto exchange. Cryptocurrencies are priced according to a pricing algorithm calculated using the formula that varies from platform to platform.

We have already described the calculation formula on the Uniswap protocol.

x * y = k

In this case, x and y mean the number of Ethers and ERC-20 tokens, respectively, available in the liquidity pool at any given time. k is a constant value, which means that the pool liquidity is permanently fixed. Other platforms may calculate asset values differently, but the main similarity is that it all happens algorithmically on all platforms.

AMM’s work is based on all the same trading pairs. However, you do not need to have a trader on the other side, as the smart contract will conclude the deal for you. This interaction is called peer-to-contract (p2c). The amount of received cryptocurrency and its price are determined automatically using a formula, so there is no need for counterparties.

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What Is AMM? The Automated Market Maker Protocol Explained

What then creates liquidity if there are no counterparties? In the AMM system, liquidity pools and their participants were invented. Let’s talk about them.

What Is a Liquidity Pool?

Liquidity providers deposit the cryptocurrencies in the liquidity pool. They get rewards in return for providing liquidity in the form of trade fees. Let’s take Uniswap as an example. The liquidity provider deposits the same amount in two tokens, for example, ETH/DAI (50/50). You want to buy all the assets in the pool. However, you cannot do it because of the x*y=k. Even if you pay more money for each Ether in this pool, the x or y cannot be equal to zero. 

Each platform determines the commission for the trader, for example, 0.3% as Uniswap does. The platforms are fighting for the best offer for liquidity providers since their existence directly depends on the level of liquidity in the pools. Here appears one more term – impermanent loss.

What Is Impermanent Loss?

The impermanent loss appears in the case when the ratio of deposited tokens changes after the deposition. The bigger the change is, the more is an impermanent loss. That’s why AMM works excellent when the coins in the trading pair are similar in their price or have minor differences. However, even when ETH/DAI pair, which was affected by the impermanent loss, the fees covered these losses. It would be best if you considered the risks before depositing a particular pair.

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What Is IMPERMANENT LOSS? DEFI Explained – Uniswap, Curve, Balancer, Bancor

What Is Liquidity Mining?

Liquidity mining is a process on an AMM platform that provides an asset to a market to receive rewards that may be denominated in the platform’s tokens. This technology is quite controversial since it has both an advantage and a drawback. There is a high risk of fluctuations in the price of provided assets. However, the benefit is obviously in the reward. The liquidity providers can sell the native tokens of the platform. 

Automated Market Maker (AMM) Examples

The Uniswap, Curve, and Balancer projects, operating on an automated market maker (AMM) model, account for more than 90% of the market for decentralized exchanges. The annual revenue of Uniswap liquidity providers is $406 million. SushiSwap has this figure at around $228 million, while Balancer has $114 million. Let’s take a closer look at each project. 

Uniswap

The first version of automated market maker Uniswap entered the market in November 2019. The platform allows anyone to deploy a liquidity pool consisting only of two pairs, one against any of ERC-20 tokens. Any trader in the ecosystem can contribute to liquidity. The platform boomed after the update in May 2020, when Uniswap launched its second version. 

As we already mentioned, the price of the tokens is determined by the balance ratio between two tokens in the pool. The most common pairs are ETH/ERC-20 and DAI/ERC-20. If you want to find out more about the Uniswap platform, we’ve made a comprehensive guide on how it works

Balancer

Balancer is an automated market-making protocol launched in March 2020. The protocol operates on a model similar to that used by decentralized exchanges like Uniswap. It is a multichannel automated marketing protocol built on Ethereum.

Balancer works as an exchange and a liquidity pool. When you’re exchanging tokens, you choose the trading pair. The service gives you an expected price slippage in which you can define the additional limit. There are also plenty of pools to join, or you can start your own liquidity pool. 

Balancer pools contain two or more tokens with arbitrary weight from the total value of the pool. Pools provide liquidity to the Balance protocol and, in return, charge traders a commission. Balancer has introduced its own governance tokens, called BALs, distributed to liquidity providers through liquidity mining.

Liquidity process in Bancor Network
Liquidity process in Bancor Network. Source: Bancor website

Curve.fi

Curve is a decentralized liquidity pool-based cryptocurrency exchange that runs on Ethereum. It is designed to serve two main purposes: to provide liquidity providers with additional income and highly efficient stablecoin trading. Curve supports DAI, USDC, BUSD, USDT, TUSD, SUSD, as well as tokenized BTC, and allows you to trade these pairs extremely quickly and efficiently.

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The platform uses an algorithm specifically designed for stablecoins. It features low fees and minimal price slippage (you can even set the maximum slippage). yToken is a special yield aggregator token that allows you to find the one with the best interest rates among all pools. The disadvantage of this method is that several protocols are used at once, which means that the risk of vulnerability is higher.

When the user provides liquidity to the pool by depositing their tokens into it, they are automatically converted into several types of tokens, based on the balance needs of the pool. For example, you can deposit 1000 DAI and get 500 USDT, 324 USDC, 150 TUSD, and 26 DAI. These indicators change all the time as people trade or deposit/withdraw funds.

Kyber Network

Kyber Network is an Ethereum-based protocol that allows instant exchange and conversion of tokens and cryptocurrencies using a high liquidity level. Kyber is similar to the 0x project but performs all the actions on the blockchain. Kyber Network provides a decentralized exchange on the blockchain without order books. It allows you to exchange digital assets at minimal cost instantly.

Kyber Network liquidity is provided through a dynamic reserve pool. The pool is formed by all reserve subjects of the system. Having multiple entities in a pool prevents monopolization and keeps exchange rates competitive. 

When a user submits a request to complete a transaction, the Kyber smart contract conducts the transaction through a reserve entity, choosing the best rate for the user. The attraction of reserve entities avoids centralization and opens the door for the listing of low-volume tokens. External reserves can be used to deal with tokens that are not listed by Kyber.

Uniswap vs. Balancer vs. Curve vs. Kyber Network

Uniswap Balancer Curve Kyber Network
Launch date May 2020 March 2020 January 2020 February 2018
Available coins About 500 103 7 72
Trading fee 0.3% 0.0001% to 10%(avg. 0.1% to 0.15%) 0.04% 0.2%
Max pool assets 2 8 custom custom
Native token UNI BAL CRV KNC
Impermanent loss prevention None Good Excellent Excellent
Trader experience Medium Medium Medium Easy
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Defi DEXs Compared: Uniswap vs. Curve vs. Balancer 

Pros & Cons of Automated Market Makers

We can’t definitely say whether AMMs are evil or good. However, there is a list of pros and cons to dot the i’s and cross the t’s. 

Pros Cons
No KYC and need to register a special account High risks of hacks and vulnerabilities
The way to launch a new token on the market Money losses in case of impermanent loss
No middlemen AMM stimulates Gas price

Future of AMMs

The decentralized economy is developing by leaps and bounds. The automated market makers are perfected slowly over the past several years. Since DeFi has such popularity now, it creates a new wave of interest in AMMs. Overall, the technology, which allows people to trade and get rewards in decentralized and anonymous space, sounds attractive. 

AMM projects are kicking the middleman that historically connected users and markets. The technology is replacing the data-keepers with lines of code. If the developers understand the necessity of analyzing the project and its smart contracts, the AMMs usage will be smooth and profitable. 

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