A detailed guide on Automated Market Maker (AMM)

Blockchain Protocol Development Company LeewayHertz

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The world can’t ignore cryptocurrency’s growing popularity and use-cases, especially as trading commodities. Though the concept of Crypto trading started with Centralized exchanges, the sovereignty of the exchange (platform) over the trader’s money soon triggered the shift to decentralized exchanges(DEXs). DEXs flourish on the peer-to-peer model by supporting users’ sovereignty, allowing them to control the platform. But a DEX often falls back in supporting the liquidity on a sufficient level.

Liquidity is a significant issue for decentralized exchanges because it is too difficult to find enough people willing to become a side in trading pairs. So, how to overcome this liquidity issue without involving any middleman? The solution came with AMM(Automated Market Maker). An improvement over traditional off-chain and on-chain order books, AMM is a protocol for operating trades on Decentralized Exchanges. AMM resolves the liquidity issue by implementing the concept of liquidity pools while retaining the core essence of the Defi ecosystem, i.e, decentralization.

Decentralized Exchanges uses Automated Market Maker (AMM) to secure their customer’s fund, and this has made AMM a popular concept in Decentralized Exchange Platforms.

An automated market works as a system that quotes a price between the two assets. An Automated Market Maker (AMM) is Decentralized Exchange (DEX) protocol that trusts a mathematical formula to price assets. Assets are priced accordingly to the pricing mathematical algorithm. The mathematical formulas can vary for each protocol. In AMM you can do trading and also add liquidity funds to the liquidity pool. This allows anyone to become a market maker on a Decentralized Exchange and can yield profit for liquidity. So let’s understand What Is an Automated Market Maker better.

What is an Automated Market Maker?

Decentralized Exchanges(DEX) focus on removing all interim limitations related to crypto trading. An Automated Market Maker is a protocol, an algorithm a formula that helps in pricing assets. AMMs help in getting fair prices on cryptocurrency thereby enabling DEXs to promote autonomy such that users can initiate trades directly from non-custodial wallets (wallets where the individual controls the private key.) Notable AMM crypto exchanges include Curve, Uniswap, and Balancer.

Instead of traditional on-chain or off-chain order books, many Decentralized Exchanges (DEX) use Automated Market Maker as a tool that allows digital assets to be traded in an automatic and permissionless manner through the use of liquidity pools. A liquidity pool is a stock of crowdfunded tokens locked in a smart contract that is used to initiate trade between two assets in a Decentralized Exchange Platform. For example, Uniswap uses x * y = k, where x is the amount of one token in the liquidity pool, and y is the amount of the other. So, k is a fixed constant, meaning the pool’s total liquidity always has to remain the same.

Other, AMMs use a different formula for different cases as per their respective target base. The only similarity between all of them is that they use a formula that determines the prices algorithmically.

How does an Automated Market Maker(AMM) work?

The next important aspect of AMM is its working module. You should know about two aspects of AMM before you learn how they function in a Decentralized Exchange (DEX) marketplace.

  • Users are not technically trading against counterparties – instead, they are trading against the liquidity locked inside smart contracts.
  • In addition, any individual can provide liquidity to individual pools by depositing the required amount of assets in the individual pool.

So in an AMM-powered DEX, you don’t need to have a counterpart to make a trade happen. Instead, a smart contract is used to operate the trade, where you directly buy or sell from the liquidity pool.

DEX functions on a peer-to-peer model that allows buyers and sellers to deal directly instead of meeting in a traditional exchange. On a Decentralized exchange, trades happen directly between two wallets and there are two types of transaction: peer-to-peer (P2P) transaction and peer-to-contract(P2C). For example, if one sells assets on a DEX, there is someone else also on the other side of the wallet who is ready to buy your asset. This is called a peer-to-peer (P2P) transaction. A (P2P) system is maintained by users who are a part of a distributed network. No one holds a central administrator or a server as each individual has its copy of files enabling both the individuals to act as a node and as a server to each other.

Inversely, AMM can be thought of as a peer-to-contract(P2C). There is no need for counterparties as trade happens between users and smart contracts. Since there is not any order book, the price you get for an asset you are willing to sell or buy is based on formula instead.

Liquidity pool – a central factor

One of the highlights of Automated Market Maker Solution refers to the fact that the buyers and sellers don’t have to wait for the counterparties to buy or sell crypto on Decentralized Exchanged. Instead, you being a seller interacting with your smart contract will initiate the trade to occur. So you still need liquidity in your smart contract to facilitate trade on DEX without the involvement of counterparties. Liquidity providers come to the rescue when a smart contract needs liquidity.

Liquidity traders add liquidity funds to the liquidity pool. The liquid pools are nothing but a massive chunk of funds that traders can trade against. Liquidity workers can earn their share of profit by contributing funds to the liquidity pool. The Automated Market Maker decides the price the fee of the liquidity provider.

Hence the liquidity providers and Liquidity pool become a major factor in the working of Automated Market Maker.

How AMM maintains liquidity in a liquidity pool?

Automated Market Maker has become an essential way to trade in Decentralized Finance (De-Fi) ecosystem. The essence of AMM is a simple mathematical formula that may take many different forms. To understand Automated Market Maker Solution for Decentralized Exchange you must understand this mathematical formula.

tokenA_balance(p) * tokenB_balance(p) = k

Uniswap a De-Fi protocol has popularised it as:

x * y = k

The constant i.e ‘k’ means there is a balance of assets that may determine the price of tokens in liquidity pools. For Example, if an Automated Market Maker has two assets such as Bitcoin(BTC) and Ether (ETH). When Ether is bought the price increases in the pool as now there is less number of ethers left than before the purchase was done. Similarly, the price of Bitcoin decreases as there are more Bitcoins now in the pool. The pool will stay in constant balance as the total value of bitcoin will be equal to the value of Ether in the Liquidity Pool. When a new Liquidity provider joins only then the pools will start expanding their size. Visually, the prices of tokens in a pool follow a curve determined by the above-stated formula.

Automated Market Maker solution by LeewayHertz

At LeewayHertz we offer Automated Market Maker(AMM) solution to Decentralized Exchanges, enabling them to achieve 24/7 liquidity by using liquidity pools. By implementing our Automated Market Maker solution, DEXs get numerous benefits above and beyond the benefit of high liquidity. Some of the key advantages of using our AMM-based DEX models are:

  • Automated and permission-less fast trading of digital assets dictated by smart contracts.
  • Users can trade against a pool of tokens without involving an intermediary.
  • Traders accomplish their trading without relying on a buyer as funds are locked in a smart contract.
  • Traders benefit from regular trading as they don’t require finding people willing to trade or match their desired price.
  • Incentivization for liquidity providers ensures the influx of assets in a pool, which helps increase the liquidity in the pool.

We offer Automated Market Maker(AMM) solution to Decentralized Exchanges, enabling them to achieve high liquidity and 24/7 available automated permission-less trading. If you are looking to implement AMM solution, get in touch to discuss your project requirements.

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Author’s Bio

Akash Takyar
Akash Takyar
CEO LeewayHertz
Akash Takyar is the founder and CEO at LeewayHertz. The experience of building over 100+ platforms for startups and enterprises allows Akash to rapidly architect and design solutions that are scalable and beautiful.
Akash's ability to build enterprise-grade technology solutions has attracted over 30 Fortune 500 companies, including Siemens, 3M, P&G and Hershey’s. Akash is an early adopter of new technology, a passionate technology enthusiast, and an investor in AI and IoT startups.

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