Everything About Automated Market Makers

What Is an Automated Market Maker

Automated Market Makers do not rely on buy-sell orders like traditional order book-driven exchanges. Instead, they depend on liquidity pools. The collection of these pools constitutes an Automated Market Maker, with each pool filled with various tokens to facilitate trading. The trading price is determined by the number of tokens in a specific pool.

Unlike traditional order books where humans handle trading, Automated Market Makers support automated trading linked to smart contracts, involving liquidity providers and decentralized finance users.

In essence, AMMs revolutionize the trading mechanism by replacing human intermediaries with algorithmic protocols. This automation enables 24/7 trading without the need for market makers to be actively present. The liquidity pools serve as the foundation, where users can swap tokens directly against the pool rather than waiting for matching orders from other traders. This design significantly improves trading efficiency and accessibility in decentralized finance ecosystems.

How Automated Market Makers Work

Imagine you're at an automated car wash. In the case of Automated Market Makers, paying the car wash machine is equivalent to depositing tokens into a decentralized cryptocurrency exchange or standalone liquidity pool.

Liquidity providers manage liquidity pools by providing specific quantities of tokens. Additionally, the smart contracts of Automated Market Makers pay providers a portion of cryptocurrency trading fees.

Every liquidity pool or decentralized exchange operates on a cryptocurrency trading platform, and users must pay trading fees to use the service. A portion of these trading fees is paid to liquidity providers as an incentive for their contribution.

The mechanism works through a continuous cycle: traders interact with pools to swap tokens, each transaction generates fees, and these fees are distributed proportionally to liquidity providers based on their share of the pool. This creates a sustainable ecosystem where liquidity providers are incentivized to keep their assets locked in pools, ensuring sufficient liquidity for traders.

The Role of Gas Fees

When conducting transactions related to Automated Market Makers, another factor is required. This includes gas fees, which are costs users must pay to use blockchain technology associated with specific ecosystems. Gas fees are not a direct function of AMM smart contracts but are determined by the underlying blockchain.

Gas fees vary significantly depending on network congestion and the complexity of the transaction. During peak usage periods, these fees can become substantial, potentially affecting the profitability of smaller trades. Understanding gas fee dynamics is crucial for users to optimize their trading strategies and timing.

Automated Market Maker activities include the following elements:

1. Facilitating token swaps using trading pairs
2. Supporting price discovery through supply-demand trading
3. Allocating cryptocurrency trading fees to liquidity providers
4. Managing liquidity provisioning across pools
5. Setting specific conditions in smart contracts to manage losses
6. Enabling yield farming conditions
7. Interacting with other protocols

Mathematical Foundation of Automated Market Makers

The standard formula for AMMs is as follows:

x * y = k

Where:

• x is the amount of asset A
• y is the amount of asset B
• k is a constant defined by the AMM

A liquidity pool contains two tokens (A and B), and the exchange of these two tokens is considered a swap of the trading pair.

The crucial point here is that the value 'k' must always remain constant. k is related to the quantities of the two tokens in the pool, so if the quantity of token X in the pool changes, the quantity of token Y must also change proportionally to keep the k value unchanged.

This mathematical relationship ensures automated price adjustment based on supply and demand. As traders remove tokens from one side of the pool, the price of that token increases relative to the other, naturally balancing the pool and preventing complete depletion of either asset.

Example

Assuming a DAI/WBTC pool has 100,000 DAI and 10 WBTC, the constant would be 10,000 x 10 = 100,000.

If someone wants to withdraw 1 WBTC from the pool, Y (the amount of WBTC in the pool) changes. At this point, X (the amount of DAI in the pool) must also change according to the k/y ratio. For example, if 1 WBTC is withdrawn from the pool, the new DAI amount that should remain in the pool is 100,000/9 = 11,111.11 DAI.

In other words, to withdraw 1 WBTC, a trader must deposit 11,111.11 DAI tokens into the pool. From another perspective, this means the price of 1 WBTC is valued at 11,111.11 DAI tokens.

The basic formula used in this process is x * y = k. However, different AMMs use various methods to maintain pool state, with some implementing more sophisticated algorithms to reduce slippage and improve capital efficiency.

Types of Automated Market Makers

Automated Market Makers can vary depending on the algorithms they use and their purposes. The diversity in AMM designs reflects the evolving needs of the DeFi ecosystem and attempts to address specific challenges in different trading scenarios.

Virtual AMMs

Virtual AMMs are those where prices are determined by mathematical models rather than actual assets held in pools. The way to understand virtual AMMs is to think of them as having virtual balances to reduce the impact of large trades. This helps reduce trading volatility and maintain stability in liquidity pools.

By incorporating virtual reserves, these AMMs can simulate deeper liquidity than physically exists, providing better price stability for traders while protecting liquidity providers from excessive impermanent loss during volatile market conditions.

Probabilistic AMMs

Probabilistic AMMs use probabilistic mathematical formulas to determine trading prices. Trading is conducted through smart contracts using complex mathematical models that account for various market factors and uncertainties.

These models often incorporate historical data and predictive analytics to optimize pricing mechanisms, making them particularly suitable for markets with high uncertainty or when dealing with exotic trading pairs that lack sufficient historical price data.

Constant Product AMMs

Constant product AMMs mostly use the x * y = k formula, according to which if the price of one asset rises due to decreased supply, the price of the other asset must fall to maintain balance. A major decentralized exchange is a representative example of this type of AMM.

This model has proven to be robust and reliable, forming the foundation for many successful DeFi protocols. Its simplicity makes it easy to understand and audit, while still providing effective automated market making functionality.

Hybrid AMMs

Hybrid AMMs can change their operating method depending on the situation. In normal trading, they operate as constant product AMMs (x * y = k formula), but when asset price volatility becomes too large and liquidation risk occurs, they switch to probabilistic AMMs. Balancer is an example of a hybrid AMM.

This flexibility allows hybrid AMMs to optimize performance across different market conditions, providing better capital efficiency during stable periods while offering enhanced protection during volatile times.

Weighted Average Price AMMs

These AMMs use special formulas that calculate asset prices by considering the quantities of both assets in the pool, rather than simply depending on the quantity of one asset. Curve Finance is primarily used for trading stablecoins, where maintaining price stability is crucial.

The weighted approach is particularly effective for assets with similar values, minimizing slippage and providing more efficient trading for stablecoin pairs and other correlated assets.

Custom Average AMMs

These AMMs have custom average formulas used to determine asset prices. Notional is an example of such custom average AMMs, designed to meet specific market requirements that standard formulas cannot adequately address.

Dynamic AMMs

Dynamic AMMs change ecosystem parameters according to market conditions. They adjust the AMM's operating method to match market changes, optimizing liquidity. 1inch is a representative example of this type.

By continuously adapting to market dynamics, these AMMs can maintain optimal trading conditions and provide better execution prices for users across varying market environments.

NFT AMMs

These AMMs are specialized market makers designed to make NFT trading easier. Since NFTs are typically low-liquidity assets, these AMMs play a role in injecting liquidity into NFT trading. NFTX and similar platforms are examples.

NFT AMMs address the unique challenges of non-fungible token trading, where traditional AMM models struggle due to the unique nature of each asset.

Lending AMMs

These AMMs are systems designed to facilitate lending and borrowing. Users can deposit assets into pools and receive interest in return. Aave and Compound are representative examples of such lending AMMs.

Lending AMMs create efficient money markets where interest rates are determined algorithmically based on supply and demand, providing transparent and accessible lending services.

Insurance AMMs

Insurance AMMs operate based on the concept of pooling assets to guarantee others' assets. Nexus Mutual is a representative insurance AMM that uses collective risk pooling to provide coverage.

Options AMMs

These AMMs enable options trading. Options trading is a method of trading derivatives of assets rather than the assets themselves. Opyn is an example of such options AMMs.

Prediction AMMs

These AMMs allow trading on specific scenarios or betting on specific event outcomes. Augur is the most well-known prediction AMM, creating markets for future events.

Liquidity-as-a-Service AMMs

These AMMs excel at aggregating liquidity from various DeFi protocols and providing it collectively. 1inch is one of the platforms offering such liquidity-as-a-service AMMs.

Synthetic AMMs

These AMMs are systems that can trade synthetic assets representing real-world assets such as stocks or gold. Synthetix is a representative synthetic AMM, bridging traditional and crypto markets.

History of Automated Market Makers

Long before AMMs or DEXs emerged, trading in traditional markets was conducted through order book systems. An order book can be thought of as a ledger recording the interest of buyers and sellers in specific assets.

Traditional market makers supplied liquidity to traditional markets and profited from buy-sell bid-ask spreads. These market makers/makers profit from both trading participants by buying at lower prices and selling at higher prices.

While traditional market makers are still useful in assets like stocks, they don't work as well in cryptocurrency markets. This is because cryptocurrency markets are highly volatile, and liquidity is often a problem, especially for difficult-to-trade token pairs.

The Rise of Automated Market Makers

AMMs officially emerged with Bancor in 2017. However, a major platform popularized AMMs in 2018. Built on Ethereum, this platform operates with smart contracts and automates the market-making process. Since 2018, there has been significant development in the AMM field regarding liquidity supply, price discovery, and handling risks such as impermanent loss.

Following this initial success, several AMM-based decentralized exchanges also emerged. With the advent of new and improved automated market maker models such as probabilistic AMMs and constant product AMMs, new possibilities in decentralized finance have opened up.

In recent years, Layer 2 solutions have also begun deploying AMM variants focused on lowering cryptocurrency trading fees.

The evolution continues with innovations in concentrated liquidity, dynamic fees, and cross-chain capabilities, pushing the boundaries of what's possible in decentralized trading.

Concept of Automated Market Makers

A simple way to look at Automated Market Makers is to view them as specialized DEX protocols. Protocols are driven by mathematical algorithms. They price each asset and manage how assets move within the decentralized finance space.

Automated Market Makers can be thought of as the engine that fuels the operation of visible DEXs, providing the underlying infrastructure that makes decentralized trading possible and efficient.

Applications in Decentralized Finance

To understand AMMs in more detail, you need to know about several DeFi applications where they play crucial roles.

Yield Farming

This is a method where liquidity providers deposit specific assets into pools and earn yields and fees in the process. Multiple yield farming platforms are operating, including various protocols that offer competitive returns.

Yield farming has become a cornerstone of DeFi, allowing users to maximize returns on their crypto holdings through strategic allocation across different pools and protocols.

Liquidity Provision

Automated Market Makers are at the core of liquidity pools. Liquidity providers supply liquidity, and based on this, they generate higher yields through yield farming. Platforms like major DeFi protocols deserve attention.

The symbiotic relationship between liquidity providers and traders creates a sustainable ecosystem where both parties benefit from the automated market making mechanism.

Trading Fee Incentives

Another use of Automated Market Makers is to provide incentives to liquidity providers using the platform. Market makers operate as standard trading interfaces, and each trade incurs a trading fee. Automated Market Makers have built-in trading fee-sharing schedules with liquidity providers, offering them incentives.

This incentive structure ensures continuous liquidity provision, which is essential for maintaining efficient markets and minimizing slippage for traders.

Arbitrage

Automated Market Makers may take arbitrage positions because their tendency to adhere to the constant value k means that asset prices within AMM liquidity pools can differ from the market. For example, if you want to buy Ethereum trading at $2000 on most exchanges from an AMM, you may need to consider the ETH/USDT balance before entering.

If people buy a lot of USDT with Ethereum, increasing the Ethereum supply in the pool, the Ethereum price may fall below the market price of $2000. These price differences provide arbitrage opportunities that help align AMM prices with broader market prices.

Loss Management

Impermanent loss is a risk factor for market makers.

The price of assets supplied by liquidity providers can move in different directions, potentially leading to liquidation risk. While it causes impermanent loss, AMMs also provide solutions for it. This can be in the form of probabilistic AMMs with special mathematical algorithms applied.

AMMs like Balancer lower assets' price sensitivity through weighted solutions. Additionally, there's Curve Finance, which primarily trades stablecoins aimed at maintaining stable value.

Understanding and managing impermanent loss is crucial for liquidity providers to make informed decisions about pool participation and risk-reward tradeoffs.

Automated Trading

Since Automated Market Makers don't require traditional market order books, peer-to-peer and automated trading are possible. Smart contracts manage the entire trading scenario, so there are no issues with order size and intermediaries.

This automation enables instant execution and eliminates counterparty risk, making trading more efficient and accessible to users worldwide.

Price Oracles

Some AMMs act as decentralized price oracles, allowing other decentralized finance protocols to access real-time price-based information. This functionality extends the utility of AMMs beyond simple trading.

Cross-Chain Trading

Several prominent cross-chain market makers, such as Synapse Protocol, Thorchain, and Ren Protocol, support users in exchanging tokens across multiple chains. Thanks to this functionality, AMMs are suitable as cross-chain bridges.

Cross-chain capabilities are increasingly important as the blockchain ecosystem becomes more fragmented, and users need seamless ways to move assets between different networks.

Asset Creation

If you can find the right AMM, it's also useful for asset creation. Companies like Synthetix can help create synthetic assets by mimicking real-world assets.

With the latest protocols leading the market, the market-making area has matured considerably. Additionally, ZK rollups and Optimistic rollups have established themselves as scaling solutions, and many AMMs are transitioning to these rollups for improved efficiency and cost reduction.

The innovation in asset creation opens new possibilities for bringing traditional financial instruments into the decentralized finance ecosystem.

Advantages and Risks of AMMs

Advantages

• Permissionless: No need for intermediaries or centralized control, enabling open access to financial services
• No Complex Order Books Needed: Automated price discovery and trading eliminate the complexity of traditional trading systems
• Liquidity Provider Rewards: Receive fees and incentives for providing liquidity, creating passive income opportunities
• Transparency: Operate with open-source smart contracts with clear rules, enabling community verification and trust
• Price Efficiency: Ensure proper price discovery through mathematical equations that respond to market dynamics
• Interoperability: Support cross-chain interactions and trading, expanding the reach of DeFi

Risks

• Impermanent Loss: Risk of asset value loss within the pool when prices diverge significantly
• Smart Contract Vulnerabilities: Potential security issues in code that could lead to fund loss
• High Gas Fees: Transaction costs can be expensive, especially on congested networks, affecting profitability
• Regulatory Risk: Increasing scrutiny from regulators worldwide may impact operations
• Low Liquidity Risk: Can lead to slippage and increased trading costs in smaller pools
• Volatility Risk: Cryptocurrency market volatility can affect pool value and returns

Future of Automated Market Makers

Automated Market Makers are transforming decentralized finance by supplying liquidity to ecosystems and simplifying cryptocurrency trading. They also enable arbitrage and yield farming opportunities.

While their potential has not been fully realized yet, AMMs are ready to drive innovation in DeFi, including new financial assets and enhanced decentralized cryptocurrency exchanges. With NFTs and virtual market makers already emerging, AMMs will further expand into areas such as lending, insurance, and real-world assets in the future.

AMMs like Velodrome and Radiant Capital have set new industry standards by introducing new mechanisms such as dynamic fees and intuitive liquidity incentives. Additionally, with the rise of DeFi 3.0, more sustainable and capital-efficient AMMs are being developed, focusing on reducing risks such as impermanent loss. Some AMMs now integrate AI-powered algorithms to optimize liquidity pools and improve trading outcomes, representing the cutting edge of decentralized finance.

The future promises continued innovation in areas such as improved capital efficiency, better risk management tools, enhanced user experiences, and deeper integration with traditional finance systems. As blockchain technology matures and regulatory frameworks evolve, AMMs are positioned to play an increasingly central role in the global financial system.

FAQ

What is an Automated Market Maker (AMM)? How does it work?

An AMM is a DEX protocol using mathematical algorithms to facilitate automated asset trading without traditional market makers. It uses constant product formulas to calculate prices and enable trades directly from liquidity pools.

What is the difference between AMM and traditional exchanges (CEX)?

AMM uses smart contracts for liquidity provision and operates decentralizedly, while CEX relies on professional market makers and centralized management. AMM enables permissionless participation, lower fees, and 24/7 trading without intermediaries.

How to provide liquidity on AMM platforms and earn returns?

Deposit equal value token pairs into AMM pools to receive LP tokens. Earn returns from trading fees and liquidity mining rewards. Your share of fees depends on your proportion of total pool liquidity.

What is Impermanent Loss (IL)? How to minimize risks?

Impermanent Loss occurs when token prices in liquidity pools diverge, reducing asset value compared to holding. Minimize risk by providing liquidity for stable coin pairs, using concentrated liquidity strategies, or exiting when price ratios normalize.

What are the differences between mainstream AMM platforms like Uniswap and Curve?

Uniswap prioritizes simplicity and general token trading with concentrated liquidity options. Curve specializes in stablecoin swaps with optimized low slippage. Each platform serves different trading needs and fee structures.

What is slippage when trading on AMM and how to reduce its impact?

Slippage is the difference between expected and actual execution price. Reduce it by using limit orders, setting lower slippage tolerance, trading during high liquidity periods, and splitting large orders into smaller portions.

What is liquidity mining? What are the risks of participating in AMM liquidity mining?

Liquidity mining rewards users for providing liquidity to decentralized exchanges. Risks include impermanent loss from price volatility, smart contract vulnerabilities, and market fluctuations. High returns accompany elevated risk exposure.

What is the mathematical principle of AMM? How does the constant product formula work?

AMM uses the constant product formula x * y = k, where k remains constant. When users trade, they exchange tokens that change x and y values, but their product stays fixed. This mechanism ensures consistent liquidity depth and pricing.