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What is AMM (Automated Market Maker) in DeFi?

BitForex Editor
Sep 07, 2020

If you're a Crypto expert, you'll understand that of all the innovations made by  DeFi, the most outstanding innovation is the Automated Market Maker (AMM), which is based Decentralized Exchanges (DEXs). They are built to permit different tokens to create and run on-chain liquidity that is openly accessible.

Fundamentally, AMMs is built to alter swapping of Cryptocurrencies between user. In place of the usual practice of buying and selling order books, each side that wants to trade will be pre-funded by the on-chain liquidity pools. For a breakdown, the liquidity pool allows various users to switch the on-chain tokens in a way that is entirely different from the normalized and decentralized manner that was previously practiced.

In this article, we'll discuss the workings, dissection, and inherent problems of AMMs, while also talking about the ways the issues mentioned could be solved. So we'll be considering them in three parts, and they are;

1.The overview of the Automated Markets

2.The problems of AMMs

3.Solutions to improve AMMs

In the course of the thorough examination and discussion of these parts, we'll understand more reasons to use the Automated Market Makers.

The Overview of the Automated Market Makers

In AMMs, we have the Market makers (MMs) who are the entities and personal tasked with determining the price as well as the trade action on an exchange that would be invalid without any trade-related activity. This usually happens when MMs buy and sell from their account with the sole aim of maximizing their profit. Liquidity is generally created from their trading activity, which stood larger trades from dropping.

Automated Market Makers (AMMs) uses the algorithmic “Money Robots” to copy the price activity within online markets like  De-Fi. There are a lot of designs existing for the decentralized Exchange, of which, out of all, AMM-based DEXs can be classified as the one that has achieved the highest liquidity and the highest trading volume amount.

According to research, Constant Function Market Makers (CFMMs) are the most common class of Automated Market Users. They have been set aside to enable the decentralized trade and exchange of digital assets specifically. The CFMMs trade is usually on a constant function, in which the remaining combined assets of traders must be unchanged. In the non-custodial AMMs, the deposit for traders is inserted within a clear contract, which any of the users can use for token swap liquidity. Therefore, traders transact against the pooled assets in contrast to other book exchange orders.

The problems of AMMs

As every good thing has a harmful effect, so also does the AMMs has its harmful effects. The difficulties facing AMMs are;

Impermanent Loss

For every trader, the most common risk and issues experienced while providing liquidity to AMM pools is that of impermanent loss, which is the difference in value recorded when tokens are deposited in an AMMs against when the tokens are held in wallets. This usually occurs when the price of tokens of an AMM varies in different directions. AMMs, unlike another medium, doesn't adjust it's exchange rates automatically; therefore the underpriced and overpriced assets will be bought or sold by an arbitrageur until the prices of the AMMs matches the one set aside by external markets. The profit made by the arbitrageur is usually taken from the liquidity providers, thereby making them record a series of loss

Low Capital Efficiency

Criticism has been thrower at AMMs for requiring large amounts of liquidity before one can achieve the same level of gain as an order book based exchange. This is because only a small portion of AMM liquidity is available before the exponential turn of the price curve. Therefore, most rational traders avoid using their liquidity because of the extreme slippage that has been experienced previously

Most liquidity providers that use** AMM** have little or no control over the pricing system offered to traders, which is why some people have referred to AMMs as a 'lazy liquidity' because of its inadequate provision and underutilization. In contrast to this, market makers that operate on the other book exchange orders can dictate the price point in which tokens can be bought and sold. This will naturally cause high capital efficiency, leading to trade-off requiring adequate liquidity provision oversight and active participation in trades.

Solutions to Improve AMMs

Every problem has a solution. Therefore, we have provided the answers to the issues above. The solutions are;

Maintaining high capital and low slipping AMMs

As it has been mentioned earlier, CFMMs allows low slippage of trades through exchange rate curves that are mostly parabolic and linear when the liquidity pool pushes itself to the limit. Therefore, all liquidity providers earn more, even though it is on a lower fee per trade basis because capitals are efficiently used. Also, arbitrageurs will profit when they rebalance the pool.

Mitigating Impermanent Loss

If the problem of impermanent loss is to be controlled, then we must make use of the pegged liquidity reserves, which directs the AMM reserve constant and it's relative values. This will help users that want to trade in maintaining the same price ratio. Chainlink can also be used to ensure that the exchanges are accurate, even if the external market price is different from the AMM toke. Price.

With the problems noted about AMMs, and the solutions being discovered, every liquidity provider shouldn't worry about the difference in price between AMMs and other external markets. Therefore, every AMMs user should trade freely and be assured of getting the best  Service on it.

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