Automated Market Makers (AMMs): A Beginner's Guide to Decentralized Trading

Ever pondered upon the inner workings of cryptocurrency swaps? The intricate mechanics behind organizing and executing buy and sell orders? Today, we delve into beginner's guide to decentralized trading and unveil the mastermind behind it all—the Automated Market Maker (AMM).

In the realm of traditional exchanges, the prevailing trade execution model is the Central Limit Order Book (CLOB). While this model boasts transparency, cost-effectiveness, anonymity, and real-time order matching, it suffers from sluggishness and necessitates the involvement of intermediaries to execute individual orders.

Central Limit Order Book (CLOB) vs Automated Market Maker (AMM)

The CLOB process is rather straightforward: buyers publicly disclose the highest price they are willing to pay, while sellers publicly indicate the lowest price they are willing to accept. Once these prices overlap, a transaction takes place; otherwise, the order remains unexecuted.

Enter the decentralized exchanges, which have devised their solution to enhance capital efficiency, speed, and user-friendliness. This innovative protocol, known as the Automated Market Maker (AMM), empowers traders to exchange cryptocurrencies without the need for intermediaries.

Although AMMs predominantly find their application in decentralized exchanges, a handful of centralized exchanges have also begun implementing AMM protocols. A prime example is Binance Liquid Swap—a liquidity pool boasting an AMM algorithm.

Operating through smart contracts, AMMs offer a completely automated trading experience. They enable traders to execute trading orders without necessitating a counteroffer, leveraging resources from liquidity pools to accomplish this feat.

But what exactly is a liquidity pool?

In essence, it is a virtual repository of funds that comprises a pair of crypto assets—let's say ETH/BTC—and operates on a specific algorithm. At its core lies a smart contract that maintains the value of the crypto pair in a constant 50:50 ratio. Participants who contribute their assets to the liquidity pool are referred to as liquidity providers, entitled to a certain percentage of fees associated with every trade within the pool.

Now, let's explore how AMMs function. An automated market maker facilitates the direct connection of users for cryptocurrency exchanges, sans intermediaries. It ensures the balance of asset ratios within liquidity pools while calculating the price of a crypto asset based on its paired token. AMMs operate on various algorithms, with the Constant Product Market Maker (CPMM) being the most prevalent.

Maintaining Asset Ratios in Liquidity Pools through AMM Formula and Example -

The primary goal of an AMM is to maintain the perfect ratio of a crypto asset pair. To achieve this, a liquidity pool is initially set up and filled with a pair of crypto tokens in a 50:50 ratio. Then, the AMM employs a simple formula:

x * y = k

Here, 'x' represents the quantity of asset A, 'y' denotes the quantity of asset B, and 'k' represents a constant.

To illustrate this with an example, let’s assume you have a liquidity pool for a crypto asset pair, such as ETH/BTC, in a 50:50 ratio. Initially, the pool is set up and filled with a certain quantity of both assets, maintaining the balance.

Let’s say you have 2 ETH and 0.1 BTC in the liquidity pool. Using the CPMM formula, we can calculate the constant 'k' by multiplying the quantities of assets: 2 ETH * 0.1 BTC = k

In this example, let’s assume the constant 'k' is 0.2. This means that no matter how the quantities of assets change withing the pool, the product of the quantities should always equal 0.2.

Now, let’s consider a scenario where buyers start purchasing asset A (ETH) in exchange for asset B (BTC). As buyers acquire more ETH, the quantity of ETH within the pool decreases while the quantity of BTC remains constant. To maintain the constant 'k', the price of asset A (ETH) will rise, reflecting the increase demand, while the price of asset B (BTC) will decline—a fundamental application of the supply and demand principle.

The significance of liquidity becomes apparent when considering slippage. Low liquidity can result in slippage, where the price of an asset experiences significant fluctuations during trade execution, significantly impacting the trade outcome. To mitigate slippage, transactions must be executed as swiftly as possible.

AMMs employ different algorithms, and some Decentralized Exchanges (DEXs) even combine two or more. Alongside the CPMM, other notable AMM algorithms include the Constant Sum Market Maker (CSMM), Constant Mean Market Maker (CMMM), Advanced Hybrid Constant Function Market Maker (CFMM), and Dynamic Automated Market Maker (DAMM).

At the heart of cryptocurrency lies the concept of decentralization, eliminating the need for intermediaries. Automated market makers embody this very idea by revolutionizing trading processes, making them faster, more user-friendly, and devoid of permission requirements. AMMs enable the trading of digital assets automatically and without intermediaries, utilizing liquidity pools instead of traditional market order books.

With their swiftness, automation, and permissionless nature, AMMs epitomize the perfect exchange mechanism for the modern era.