Financial markets need liquidity and efficient processes for participants to trade assets effortlessly. In the world of crypto and decentralized finance(Defi), automated market makers stand out to be an essential element.
Unlike traditional financial markets, the Defi ecosystem does not rely on traders or other participants to create liquidity of assets in the market. But, an AMM system ensures that liquidity is maintained in the financial markets through liquidity pools.
Therefore, an AMM is an automated system that ensures one can trade crypto anytime.
What is an Automated Market Maker?
So, the next time you use a decentralised exchange platform, the liquidity of the assets is created by such AMM systems. Using decentralised exchange platforms is relatively new in the crypto space, so buyers and sellers can hinder the liquidity of assets in the market.
However, this is where an AMM system comes into play as it creates pools of liquidity wherein anyone on the platform can contribute assets, and the prices of the assets in the pool are determined by a mathematical formula or an algorithm.
Before the Introduction of AMM
When there were no AMMs in the industry, order books were the game’s name. Users did every transaction through order books. It is a perfect system to conduct transactions if there is enough liquidity of assets in the market. However, if the market lacks liquidity, you will be able to place an order for the asset but not find a match for the order. This increases the chances of price slippage and increases price volatility.
Due to slippage and lag in price delivery, AMM systems are much better than order books, especially when trading a highly dynamic asset such as crypto.
The Advantages of Using Automated Market Makers
- It is an effective system for markets with fragmented liquidity as long as there are enough people to invest in the liquidity pool.
- In the traditional method, there is often a lag in price discovery, but AMM traders can instantly get to know the price of an asset.
- When a crypto exchange platform is based on AMM, it reduces the latency to an extent where it is measured in milliseconds rather than seconds.
- Reduces unfair and unethical trade practices as it eliminates the ability to do front running, wash trading, and price manipulation.
- Price slippage is reduced by a great extent and is measured in fractions of cents.
- AMM systems allow for orders to be completed in a matter of seconds.
- Reduces pricing swings which help to increase the profit margin of the traders.
Top AMM protocols Used in the Decentralised Finance Ecosystem
- Uniswap – This protocol was introduced in November 2018, and it is an open-source protocol. It works to provide immediate and automatic liquidity. Uniswap uses a mathematical equation to determine the ratios of the tokens in the pool to keep the markets stable.
- Curve – Another open-source Defi protocol makes stable cryptocurrencies more liquid and works as a Decentralised Exchange.
The use of AMMs is helping to make the crypto economy decentralized and provides users with a better way to swap and trade tokens.