Automated Market Maker, an underlying protocol, is a part of decentralized finance (DeFi) that empowers all decentralized exchanges (DEXs). DEXs enable users to exchange cryptocurrency by interacting with other users directly, without an intermediary.
Simply put, automated market makers are trading mechanisms that eliminate the requirement for centralized authorities like financial entities or exchanges. Besides, these protocols use Smart Contracts to define digital asset prices and provide liquidity, then pool it into smart contracts.
Instead of trading against counterparties technically, users are trading against liquidity locks inside smart contracts called liquidity pools. Only high-net-worth individuals or companies can suppose a liquidity provider role in traditional exchanges. In AMM, an entity may become a liquidity provider when it fulfills the requirements hardcoded into the smart contract.
The AMM technology represents the ideals of Ethereum, crypto, and blockchain technology without the authorization of entities. Examples of automated market makers are Uniswap (launched in 2018), Balancer, and Curve. Learn more about AMM and its working.
What is an Automated Market Maker?
A marker maker facilitates the liquidity process for trading pairs on centralized exchanges that oversee the operation of traders. Besides, they provide an automated system to ensure the match of trading orders.
Centralized exchanges depend on professional traders to provide liquidity for trading pairs and to get a fluid trading system. In this system, liquidity providers act as market makers and facilitate the process required to provide liquidity for trading. These entities match retail traders’ orders through multiple bid-ask orders, and exchange ensures the availability of counterparties for all trades.
How do Automated Market Makers work?
An automated market maker works like an order book exchange that contains trading pairs, such as ETH/DAI. However, you don’t require a counterparty on the other side to make a trade. Instead, you interact with a smart contract for market preparation.
On Binance Decentralized Exchange, trades happen directly between customers’ wallets. If you sell BNB for BUSD, there is someone else on the other side who is purchasing BNB with his BUSD. Binance exchange holds this process called a peer-to-peer (P2P) transaction. On the other hand, AMM is called peer-to-contract (P2C), which doesn’t require counterparties traditionally, as trades happen between users and contracts.
A formula determines the price for the asset you want to buy or cell. It is worth noting that some future AMM designs face this limitation.
What is the Role of Liquidity Providers in AMMs?
Liquidity lets automated market maker function adequately, and the pools that don’t receive funds are susceptible to slippage. AMMs encourage customers to pool digital assets in liquidity pools to reduce liquidity so other users can trade against funds.
As its name implies, AMMs issue governance tokens to liquidity providers and traders. When an LP (Liquidity Provider) exists from a pool, he redeems the LP token and receives a share of transaction fees. As an incentive, the AMM protocol prizes liquidity providers with a fraction of the cost paid on pool-executed transactions.
Yield Farming Opportunities on AMMs
Apart from incentives, LPs can also take advantage of yield farming opportunities that increase their earnings. To enjoy this benefit, you should deposit a proportion of digital assets in a liquidity pool on the automated market protocol.
After ensuring the deposit, the AMM protocol will send you LP tokens that you will separate into a lending protocol. Notably, you must redeem the liquidity pool tokens to withdraw your funds from the liquidity pool. While doing this, you will maximize your earnings by capitalizing on the interoperability of decentralized finance protocols.
What is Impermanent Loss?
Impermanent loss is a risk with a liquidity pool that occurs when the price ratio of pooled assets fluctuates. An LP takes a loss when the proportion of the accumulated investment on value deviates from the deposited-funds price. Impermanent loss affects the volatile digital assets-based pools.
However, this is an impermanent loss as it is likely that the price ratio will return. The loss becomes permanent only if the liquidity provider withdraws said tokens before the price proportion converts. You can cover such losses through transaction fees and potential earnings from LP token staking.