For a long time, exchanges were forced to use order books, which had to be both filled in and analyzed manually. Therefore, there were serious restrictions on the speed and efficiency of work. But with the widespread use of computers, automatic systems and the Internet, the situation has changed - the traditional principles and approaches have been replaced by automated market makers or AMM.
What is AMM?
At its core, AMM is programs or algorithms in which a clear sequence of actions is set. "If ... then ...". That is, full automation and independence from human control. Understandably, this quickly caught on in the blockchain industry, which initially relied on algorithms, software and smart contracts. However, it was not enough to simply automatically fulfill certain conditions. A so-called “liquidity pool” was needed, providing a great opportunity for finding trading pairs. And since the time these pools began to be actively created, the interest in automatic market making has increased significantly.
How does automatic market making work?
There are several approaches to ensuring the stability of automated systems.
Constant Function Market Makers (CFMMs) are market makers with permanent functionality. The most common AMM class. They have been specifically designed for the decentralized exchange of digital assets. A distinctive feature is the constant functionality. This is ensured by the direct interaction of smart contracts responsible for different trading pairs, without the need to enter information into the order book or directly to the counterparty. The price of tokens is additionally regulated by external mechanisms - either by regulators or by special smart contracts.
Further development of this idea - Constant Product Market Maker (CPMM). They include automatic regulation of price ranges. This is achieved due to stable liquidity for two pairs of tokens. If we take the initial amount of one of them as X, and the second as Y, then the product X * Y = const. If the quantity of one increases greatly, then its price, accordingly, decreases. And smart contracts are automatically triggered to even out the ratio.
The second approach, Constant Sum Market Maker (CSMM), does a better job at predicting, but it does not work as efficiently when one of the tokens is depleted, because only the total amount of assets is constant. That is, X + Y = const. Therefore, this regulation system is used less often than the previous one.
The third approach is even more difficult - Constant Mean Market Maker (CMMM). But it allows you to work with more than two pairs of tokens and allows you to maintain an average weight outside the 50/50 distribution. The weighted average geometric value remains constant here. For three assets, for example, the equation looks like this: (X * Y * Z) ^ 1/3 = const.
An important point. Whatever mechanism regulates the stability of the system, the market maker himself makes a profit only if he participates in the formation of the liquidity pool. Since all bonuses (ideally) are paid exactly to those who provide finance for the effective operation of AMM.
It is also worth clarifying the meaning of the term "slippage". This is a situation when the execution of an order is carried out at a cost that differs from the declared one due to delays necessary either to confirm, or to find the necessary liquidity, or for any other reason.
Advantages and disadvantages
The benefits of AMM include the following:
- The emergence of new trading models.
- Insignificant price slippage - from one hundredth of the original value.
- Very fast and the cheapest possible creation of an analogue of the "order book".
- The delay of trade calls in milliseconds.
- Great liquidity in the markets.
- Attackers have fewer chances to manipulate prices or form “kitchens”.
- Fewer price fluctuations.
- An increase in net profit, which in turn attracted more institutional investors to the market.
With the cons, everything is much more complicated, so it is worth dwelling on each in more detail.
Intermittent loss. In short, the possibility of a significant difference in value between the moment the token is deposited and the moment it is withdrawn. Moreover, if the crypto assets were banally stored in the wallet, such a situation would not arise. This is due to the mechanisms of automatic regulation mentioned above, due to which the price of a certain asset can significantly differ from the market price for some time. However, since this price is bound to come back to normal, therefore, the losses are “volatile”. Unfortunately, this is only in theory. In practice, liquidity providers often suffer losses that even exceed their commission.
Multitoken exposition. AMM requires liquidity providers to place token pairs in order to provide equal liquidity for all parties to a trade. Therefore, you have to take additional risks, dividing the desired investment into two assets, one of which is much less stable than the second. This also reduces the potential profit from the placement of the base token.
Low capital efficiency. One of the points where AMM is often criticized is the need for significant liquidity to provide the same level of slippage as on centralized exchanges. Because a significant part of liquidity is available only when the pricing curve becomes exponential. And this happens very rarely, so most of the assets are either not used or are not used effectively enough. Accordingly, the profit is much less than similar investments in centralized exchanges.
Examples of using
The following can be cited as effective projects using AMM technology:
Kyber Network. One of the first AMMs that started using automated liquidity pools back in 2018. At the same time, either large market makers or the project team became suppliers, and, alas, no free delivery is provided. The price of tokens in the pool is set either by external oracles or by automatic settings of smart contracts. This is necessary for more effective control of the situation during periods of high volatility.
Uniswap. The first decentralized AMM to hit the market in November 2019. Anyone can participate in the creation and formation of the liquidity pool and receive a reward for this. The token price is not additionally regulated by anything - only by the internal mechanisms of the pool (the ratio between the number of tokens).
Balancer. Essentially similar to Uniswap, but offers new dynamic features that go beyond a simple pool of two different tokens.
Curve. One of the latest AMM projects launched in early 2020. Pools can be created exclusively by administrators, but anyone can contribute assets there. But there is one "but". The pool can only contain stablecoins. This allows you to execute large trades with minimal slippage and attract large investors.
Conclusions
It is automatic market making and the associated liquidity pools that have attracted the closest public attention to decentralized finance. And while this method of work still has some drawbacks, it is still very promising.