What are Automated Market Makers (AMMs) And Why Are They Important?

Automated market markers, also known as AMMs, are a set of decentralized exchange platforms that depend on a mathematical formula to set the price for a token.

Similar to traditional online exchanges, they have numerous trading pairs, such as Ether (ETH) to Dai. However, there are no buy or sell orders, and traders do not have to find someone else to sell their crypto coins to – instead, a smart contract acts as the maker in an exchange transaction.

The idea is similar to quick-swap services such as Changelly and ShapeShift, but the difference is that the firm’s reserves are substituted with liquidity pools based on smart contracts. A liquidity pool has two assets in a trading pair, and the relative percentage of every token in that pool is what decides the hypothetical price of a particular asset. The first live AMM was Banchor, but one of the most popular platforms are Uniswap, Curve, and Balancer.

Why do These Exchange Platforms Exist?

Overall, they make providing liquidity much simpler and more affordable. Automated market makers are an effort to work around the performance restrictions of smart contract blockchains – Ethereum, in particular.

Before AMMs became popular, decentralized exchange platforms created on Ethereum tried to use a classical order book mechanism. Still, they encountered liquidity issues, as placing each order needed spending gas and waiting for block confirmation times. Ethereum’s low flow rate also meant that only a few transactions could be sent out before these orders would fully swamp the blockchain.

This was more of an issue for market makers, the liquidity providers on order book exchanges. ‘Making’ a market usually asks for constantly changing buy and sell orders to the latest price, although they do not get filled. When each order sent out costs money and time, they may lose more than they gain from the bid and ask spread, which is the difference between the highest offered buy price and the lowest sell price.

AMMs make offering liquidity much cheaper and simpler via an entirely automated one-time process. Even average users are allowed to pitch in with their liquidity, although doing so on traditional exchange platforms asks for advanced technical knowledge.

How do Smart Contracts Automate Trading on AMMs?

When trading on an AMM, users engage with the liquidity pool. Beneath the cover, when the user programs the smart contracts to carry out a trade, the contract sends their tokens, such as ETH, to the liquidity​ pool. Next, a mathematical formula determines how many tokens from the other side of the pair, for instance, Dai, they should get in return for their ETH.

​Every trade has a certain amount of slippage – how much the size of the order impacts the final price at which a token was purchased or sold. The arc shape means that slippage will be low on small orders, but slippage increases significantly when it comes to large orders.

The Bottom Line

So, what is the reason behind AMMs becoming popular? Simply put, because decentralization and permissionless use are potent advancements in the cryptocurrency industry.

Automated market makers are, possibly, already solving the most prominent obstacle to the widespread adoption of decentralized exchange platforms (DEXs): liquidity. Without a problem, the inherent advantages of a DEX can be seen. Dissimilar to traditional centralized exchanges, there are no doormen that could rule out projects or users.

AMM protocols are also permissionless and do not ask users to set up specific accounts or pass stringent Know Your Customer checks. A wallet address is all that is required to engage with the protocols. Moreover, AMM decentralized exchanges usually have straightforward interfaces, as they do not need to pack advanced order options or price charts into a dashboard.

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