Automated Market Makers (SMPs) are an increasingly popular branch of decentralized finance (DeFi) and come under the specific subset of decentralized exchanges (DEXs). The broad goal of AMM is to reduce the number of moving parts that facilitate cryptocurrency transactions by replacing limit orders (and the resources needed to execute them) with an automated token price valuation tool. Sounds complicated, right? Well, admittedly it is a concept that experienced crypto traders can understand more easily than laymen. Simply put, however, it is not beyond your understanding.
How do automated market makers work?
To explain how SMPs work, we will first clarify a few conditions.
First, ERC-20 tokens. These are tokens specially designed for use on Ethereum blockchains.
Then liquidity pool. This term has been described as “levels at which price often ‘makes a decision’ when a large number of orders enter the market ”. Think of a pool of liquidity as the intersection of orders that ultimately determine where an asset is priced. Or just think of it as the delivery of a particular asset, which determines the price of that asset.
Now, on to automated market makers. AMMs are cryptocurrency trading platforms usually built using the Ethereum blockchain and with a liquidity pool of ERC-20 tokens, as well as other types of coins. The liquidity pool that funds SMPs performs the role of limit order books in other types of exchanges. Traditionally, an exchange host would have to process buyers and sellers’ orders to acquire or sell assets, and then find a matching party that agrees to the terms of the limit order or sale. Not so with SMPs.
On the contrary, an algorithmic smart contract constantly monitors the storage of assets in the liquidity pool. As certain tradable assets are bought in larger quantities, their supply decreases and their price increases accordingly. If an ERC-20 token in the liquidity pool is deposited back into the liquidity pool, its availability increases and thus the price decreases. The algorithm uses these relative stocks of certain tokens to determine their price in real time. Rather than issuing buy or sell orders and arranging trading lots, the algorithm simply sets the price, and buyers and sellers are free to trade based on that price range.
What are the benefits of SMPs?
The advantage of automated market makers can be discussed with regard to centralized markets and decentralized exchanges (DEXs). The main advantage of SMPs over centralized alternatives is their decentralization. Rather than requiring human parties to match and process purchase orders (and potentially perform other administrative tasks required for a centralized exchange), smart contracts take the central role in SMPs.
In general, there are several advantages of decentralized governance. They contain:
- Less middlemen
- Less chance of human blunder
- Fewer parties that justify their efforts by getting value from the product (which often means the user)
Some “decentralized” forms of cryptocurrency exchange are only partially so, as they may have certain features of decentralization but ultimately have a centralized governance system. For example, a stock exchange may outsource the processing of buy and sell orders to people in the name of opportunity, or may have a centralized board of human directors. In the case of SMPs, decentralization rules to a large extent (although the precise design of each SMP must be evaluated individually). Placing algorithmic smart contracts at the heart of pricing and order fulfillment alone illustrates the decentralized nature of SMPs.
So what are the benefits of this decentralization, in real terms? They are:
- Pricing, because it is determined mathematically, can be set out in extensive detail (see Uniswap’s explanation about how it prices assets)
- The total liquidity of an SMP can be determined, which maintains a degree of price predictability for buyers and sellers
- No third parties are needed between trading partners as the contract governs the execution of transactions
- AMMs represent an efficient, streamlined way to trade cryptocurrency (at least in theory, since every AMM is different)
Another feature of SMPs is that those willing to provide liquidity to these markets may be able to do so and bring home some extra coins for their service.
How do SMPs benefit from liquidity providers (LPs)?
You may by now understand that liquidity is critical to making SMPs work. With no assets in the treasury, the whole operation falls apart– smart contracts cannot set prices (which are based on the liquidity of specific assets) or make trades when there are no assets to trade. So where does the liquidity in these automated markets come from? Basically, it comes from liquidity providers (LPs). Different types of SMPs may depend on liquidity providers to varying degrees, but they are important in all cases.
Liquidity providers have a clear incentive to provide assets to the pool: fees and possibly interest. LPs can generally receive a portion of the trading fees in exchange for providing liquidity to the market.
The crypto assets that LPs offer generally serve a number of purposes:
- To reduce the amount of “slippage” or difference between the projected price of an algorithm and the actual executed price of a trade, which can be due to drastic and sudden changes in supply
- To provide liquidity for the fulfillment of transactions
These LPs provide a crucial service to SMPs and can generally get it right. However, there is a risk of pledging their assets to markets as negative changes in the value of their tokens due to market forces in a specific SMP can lead to a phenomenon known as transient loss.
What is the future of SMPs?
Right now, the four big fish in AMM’s are Uniswap, Kyber, Bancor and Curve. These have proven to be viable resources for cryptocurrency trading and appear to be an integral part of the growing decentralized finance (DeFi) sector. There is clearly an appeal to SMPs. Indeed, the ability to create a largely self-regulated cryptocurrency swap market has great appeal to those who hate brokers.
There are also challenges. Attracting and retaining the support of liquidity providers is just one of those challenges. As confidence in legacy financial systems continues to wane, the future of SMPs may become clearer. Will these automated markets become increasingly popular, and thus sustainable, or will the challenges prove too great to live a long life?