In the previous article, we explored the concept of Total Value Locked (TVL) and why it is an important metric for measuring adoption in the decentralized finance (DeFi) ecosystem. Many of the leading DeFi protocols that drive TVL figures are powered by automated market maker (AMM) technology. But what exactly are AMMs and how do they work?
What is an Automated Market Maker?
An automated market maker (AMM) is a type of decentralized exchange protocol that relies on smart contracts and liquidity pools rather than traditional buy and sell orders. AMMs allow digital assets to be traded directly between users in a permissionless and automated way.
Some key features of AMMs:
- Uses liquidity pools instead of order books
- Prices set algorithmically based on pool balances
- No need for counterparties or intermediaries
- Highly decentralized and transparent
- Support swapping and liquidity providing
- Leading DeFi protocols use AMM models
Uniswap, Curve, Balancer, Bancor and many other DEXes operate as AMMs. They have quickly risen to prominence in DeFi due to their ease of use and efficiency.
How does an AMM work?
The core component of an AMM is its liquidity pool. A liquidity pool contains a pair or set of tokens that are locked in a smart contract. For example, a pool could contain ETH and USDC.
Instead of matching individual buyers and sellers, the AMM itself acts as the counterparty to all trades. When a user wants to swap ETH for USDC, they don't place an order - rather the smart contract executes the trade automatically at the current price.
Prices are set by a mathematical formula based on the relative balance of assets in the pool. As one token is traded, its balance decreases while the other asset increases, moving the price. Arbitrage traders are incentivized to rebalance the pool when it drifts from the market price.
Liquidity providers can stake their own tokens in pools to earn trading fees from the protocol. This user-supplied liquidity is the backbone of AMMs.
Key benefits of AMM models
AMMs introduce major improvements in efficiency, cost and accessibility compared to traditional exchanges:
- No order books: Removing order books simplifies trading to a single transaction.
- Low fees: Trading fees are typically 0.3% or less, far lower than centralized exchanges.
- High liquidity: Pools attract ample liquidity, ensuring fast swaps even for large amounts.
- Censorship resistance: No KYC requirements means anyone can freely trade without restrictions.
- Composability: AMMs are modular money lego pieces that can be plugged into other DeFi apps.
- Constant uptime: AMMs are always online and can never be shut down since they are decentralized.
These benefits explain the surging popularity of DEX protocols based on AMM technology.
Impermanent loss in AMM pools
There is one notable downside for liquidity providers known as impermanent loss. Due to the balancing mechanism, if the market price of the tokens diverges from the pool price, LPs can lose money compared to simply holding the assets.
However, trading fees are designed to help offset these losses. Also, since the loss is "impermanent", LPs can regain their original capital by withdrawing once prices realign.
AMMs represent a breakthrough innovation that is driving the growth of decentralized trading and exchanges. Their automated, trustless approach unlocks greater efficiency and access for all. The self-balancing nature of AMM pools has enabled billions in value to flow into DeFi apps to date. Going forward, expect AMM technology to continue proliferating as more assets and use cases move on-chain.