PYMNTS DeFi: What Is an Automated Market Maker?

Welcome to the PYMNTS series on Decentralized Finance (DeFi).

In these articles, we’ll look at all the parts of DeFi that are the biggest, hottest, most rewarding, and most risky parts of the blockchain revolution. Finally, you’ll know what DeFi is, how it works, and the risks and rewards of investing in it.

See Part 1. What is DeFi?

See Part 2. What are the top DeFi platforms?

See Part 3. What is a smart contract?

See Part 4. What is Yield Agriculture and Liquidity Mining?

See Part 5. What is staking?

See Part 6. What are the top 10 uses of DeFi?

See Part 7. Unpacking DeFi and DAO

See Part 8. Very realistic risk of DeFi

See Part 9. What is the Top DeFi Blockchain?

See Part 10. What is true, what is hype, what is important

See Part 11. What is Algorithm Stablecoin?

In this series, we explained what DeFi is and how to use it. But if you want to know how DeFi works and how its tools can be used in other parts of the financial world, you need to understand Auto Market Maker (AMM).

Start with a traditional market maker who is essentially a wholesaler that guarantees a market that works smoothly by providing liquidity. Market makers are generally large banks or financial institutions that guarantee that securities are bought (bid) at a specific price and sold (requested) at another price, so sellers are buyers seeking a specific amount. You don’t have to look aggressively. Of a particular share at a particular price. Market makers make a profit with bid door spreads.

This is a proven system used by many exchanges. It’s also a financial intermediary, generally a cryptocurrency, and I especially hate DeFi. After all, getting rid of them was the central goal of Bitcoin creators.

Especially in the absence of centralized control, at least in theory, decentralized exchanges (DEX) have no room for traditional market makers.

DEX can automate the process of directly matching buyers and sellers, but with the same problem. With the exception of Bitcoin, Ethereum Ether, and a few other major cryptocurrencies, most of the thousands and thousands of cryptocurrencies have substantial liquidity issues.

So how do you decentralize centralized cash-intensive functionality? You crowdsource it.

Top DeFi exchanges such as Uniswap, SushiSwap, PancakeSwap, Curve Finance and Balancer all use AMM smart contracts and run combined with billions of dollars per day.

The mechanism used by AMM is the liquidity pool. It provides to those who have cryptocurrencies to invest their earnings based on transaction fees, and in some cases rewards in the form of tokens in the pool itself. This is where liquidity mining comes in.

reference: PYMNTS DeFi Series: What is Yield Agriculture and Liquidity Mining?

Liquidity providers lock cryptocurrencies (eg Ethereum, or ETH) into the pool and exchange tokens for the pool itself. When they want to withdraw ETH, they burn pool tokens.

These are governance tokens voted by Decentralized Autonomous Organizations (DAOs) that can pool issues such as withdrawal conditions for cryptocurrencies locked in the pool and the size of charges charged.

Pools often compete based on the size of the fee, the amount of liquidity, and the trading volume of the token in question. Of course, like DEX and centralized cryptocurrency exchanges, they are subject to hacking and fraud.

Yes, but …

It’s not that simple. The DEX liquidity pool can handle specific trading pairs (for example, ETH and stablecoinUSDCoin as ETH / USDC). Or, in some cases, there are several different cryptocurrencies in the largest pool.

Suppose the ether is priced at $ 3,500 and the USDC is $ 1. If you include one ETH, you will get 3,500 USDC minus transaction fees. The fee will be returned to the pool members based on the percentage of the pool members in the total pool funds.

At this point there is a big “but” — slip.

Traders agree to swap when they are written to the blockchain and the trade is complete. In Ethereum, the block time is usually 12 to 15 seconds. This means that the price of a very volatile cryptocurrency will have time to change between an ask or bid and a running transaction.

For bulk orders or expensive cryptocurrencies, this can be a killer if the volatility is high. However, as DEX travels to Ethereum competitors such as Solana and Cardano in a much faster block time, slippage can become a thing of the past.

read more: PYMNTS Blockchain Series: What is Solana?

reference: PYMNTS Blockchain Series: What is Cardano?

There may also be a bright future for AMM-powered DeFi exchanges, as there are no intermediaries or paying managers, which increases liquidity and reduces slippage.