AMMs (automated market makers) have gained a lot of traction, owing to their ability to replace the traditional exchange-listing procedure and limit-order books with permission less liquidity pool managed by algorithms.
The Automated Market Maker is a mechanism for automating digital asset trading without the need for authorization, with trades conducted automatically using liquidity pools to replace buyers and sellers.
It is a type of decentralized exchange (DEX) technology in which asset prices are set by a mathematical formula. This formula replaces order books on a traditional exchange, where asset prices are determined by pricing algorithms.
The formula for each protocol may differ. Most DeFi Protocols including Solana Blockchain use a simple x*y = K equation, where x denotes the quantity of one token and y denotes the number of other tokens in the liquidity pool.
This Automated Market Makers (AMM) is an underlying protocol of the Decentralized Finance (DeFi) Ecosystem, and it contributes to its improvement.
How does AMM work?
In every trading exchange, an Automated Market Maker works in the same way as order books. However, there are two points to understand when it comes to AMMs.
- Trading pairs in AMMs exist as ‘liquidity pools’. Trading takes place directly between user wallets without any need of a buyer or a seller. If you want to trade ether for tether, for example, you’d need to find an ETH/USDT liquidity pool.
- Anyone can supply liquidity to these pools instead of utilizing dedicated market makers by depositing both assets represented in the pool. If you want to become a liquidity provider for an ETH/USDT pool, for example, you’d have to deposit a particular amount of ETH and USDT.
AMMs employ predefined mathematical calculations to ensure that the asset ratio in liquidity pools is balanced and feasible in order to prevent discrepancies in the pricing of pooled assets. Many other DeFi exchange protocols use a basic x*y=k equation to set the mathematical relation between assets maintained in the liquidity pools,
Let’s look at an ETH/USDT liquidity pool as an example to understand how this works. When traders buy ETH, they add USDT to the pool and take ETH out of it. As a result, the amount of ETH in the pool decreases, causing the price of ETH to rise to achieve the x*y=k balancing effect. The price of USDT, on the other hand, falls when more USDT is introduced to the pool. When buying USDT, the price of ETH falls in the pool while the price of USDT rises.
Role of liquidity providers
Liquidity providers contribute assets to liquidity pools in the form of money. AMM is beneficial to many DeFi protocols since they include liquidity pools that allow users to act as liquidity providers and add funds.
Automated market makers like Solana Blockchain are a staple in the DeFi world. They make it possible for almost anyone to create markets quickly and easily. While they have limits when compared to order book exchanges, the overall innovation they provide to the crypto world is priceless.