Automated Market Maker — A Full Beginner’s Guide

If you use decentralized exchanges to trade your crypto coins, you have probably come across the term Automated Market Maker or AMM.

To make things clearer, we created a guide in which we’ll explain how AMM works and what are its main advantages and disadvantages. You’ll also find out what differentiates liquidity providers from market makers.

What Is an AMM?

Automated market makers or AMMs are part of the DeFi ecosystem. Their main role is to enable crypto trading. However, instead of using order books, AMMs use smart contracts. This means that all trades are automated and there is no need to use intermediaries.

Additionally, the AMM protocol uses algorithms within the liquidity pool to determine prices and match buyers and sellers. This enables continuous trading. Although each decentralized exchange uses different mechanics, the general idea behind automated market makers is to improve liquidity, speed up transactions, and reduce transaction fees.

How Does AMM Work?

As mentioned before, AMMs enable automated trading on decentralized exchanges. However, unlike traditional trading that uses order books, AMMs use smart contracts and liquidity pools.

Namely, after traders lock their crypto tokens in the pool, AMMs will use an algorithm to determine prices based on their ratio in the pool.

That said, AMMs generally use the following formula to determine the prices of tokens within the pool:

X * Y = K

The letters X and Y represent the supply of A and B tokens, while K refers to a constant factor.

To better understand how this formula works, take a look at the following example.

If token A has a supply of 2000 USDT, and token B has a supply of 1 ETH, their constant will be 2000 — 2000 x 1 = 2000.

However, if someone buys ETH, its price will go up because its supply within the pool will decrease. On the other hand, if someone sells ETH, its price will go down since its number in the liquidity pool will increase.

That said, this formula will vary depending on the AMM model, which brings us to the next section.

Automated Market Maker Models

There are three automated market maker models — constant product market maker, constant sum market maker, and constant mean market maker. Here’s how they differ.

Constant Product Market Maker (CPMM)

CPMM is the most widely used model that applies the X * Y = K formula to set the prices of tokens in the liquidity pool. Here, the values of tokens X and Y depend on their supply. In simpler terms, if the supply of token X goes up, its price will fall. The same goes for token Y. This model is utilized by platforms such as Bancor and Uniswap.

Constant Sum Market Maker (CSMM)

The CSMM model is based on the following formula: X + Y = K. In this protocol, prices are based on the total sum of two tokens.

Its goal is to allow liquidity providers to extract their tokens if their off-chain price is not 1:1. However, the CSMM model is rarely used because it doesn’t provide infinite liquidity.

Constant Mean Market Maker (CMMM)

The CMMM model enables the exchange of any digital asset within the liquidity pool. On that note, unlike the CPMM and CSMM models, it enables the use of more than two pairs of tokens. This also means that it doesn’t utilize the standard 50/50 distribution.

To determine the prices of tokens, the CMMM model uses the (X*Y*Z) ^ (⅓) = K formula. The Balancer was the first platform that used this model.

Advantages of AMMs

The main benefits of using AMMs in decentralized exchanges are:

They Contribute to Decentralization

AMMs contribute to decentralization by enabling P2P trading. This eliminates the need for intermediaries. Moreover, since all trades take place on the blockchain, AMM transactions are much faster and cheaper.

And finally, since nobody regulates decentralized exchanges, anyone can trade their assets, regardless of their country’s financial regulations.

Liquidity Provision

The introduction of the AMM DeFi protocol in crypto trading enabled all crypto enthusiasts to become liquidity providers. Namely, anyone who locks their digital assets in a smart contract within the pool can become an LP. This encourages crypto holders to become part of the DEX ecosystem and to improve the liquidity of digital assets.

They Enable Continuous Trading

Unlike traditional exchanges that allow trading only during a certain period, platforms that use AMM protocols are available 24/7. This allows traders from different time zones to trade continuously.

Disadvantages of AMMs

The main challenges of using AMM protocols are:

Capital Inefficiency

Most of the crypto tokens that are inside liquidity pools are inefficiently allocated. Why? Since significant changes in prices occur very rarely. On a positive note, this doesn’t affect the fees that LPs receive for their contributions.

Impermanent Loss

Impermanent loss occurs when the price of a token within the liquidity pool deviates from its market price. If this happens, traders will lose a portion of their deposited assets.

Price Slippage

Price slippage is another challenge that AMM protocols can face. This term refers to the difference between the expected price and the actual price. Slippages are the most common in large trades. Namely, larger trades equal lower rates.

Liquidity Provider vs Market Maker

While both LPs and MMs contribute to liquidity, what differentiates them is their approach to trading.

The role of LPs is to deliver buy and sell orders to improve market liquidity. They do this by locking their crypto tokens into liquidity pools. These tokens are then used by other traders, while LPs receive rewards for each successful trade. In short, LPs are there to keep the supply and demand for crypto assets active.

On the other hand, the role of market makers is to continuously issue buy and sell orders. They are also a bridge between buyers and sellers as they quote both the bid and the asking price. This approach helps in equalizing the market price between buyers and sellers. Market makers also contribute to creating more predictable trading conditions.

How to Make Money With AMM

Market makers receive income, or taker fees, every time users trade against the bids. In addition to that, MMs will charge fees for their services. The amount of fees will depend on the trading activities and policies of the decentralized exchange.

Best AMM Crypto

Here’s a list of the best AMM crypto coins:

Conclusion

Automated Market Maker is an algorithm that enables the exchange of tokens through smart contracts. Unlike traditional exchanges, the AMM protocol allows continuous trading. It also sets the price of crypto tokens within the liquidity pool automatically.

In most cases, the AMM algorithm uses the formula X * Y = K to determine the prices of crypto assets. However, this formula will vary depending on the AMM model. The main advantage of AMM lies in its contribution to decentralization. On the other hand, its biggest drawback is related to price slippage.

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