Explanation of AMMs: Automated Marker Makers

If you understand how AMM (Automated Marker Makers) work and are useful, then you will understand the whole issue of decentralized platforms. You will also understand the empty force of DeFi because it has been at the origin of many innovations in the sector.

It is indeed one of the applications which in DeFi has enabled the innovations that we have experienced. Everything you know about Liquidity Mining, Yield Farming etc, all of this was originally created because of AMM (Automated Marker Makers).

Finally, to be exact, these are two kinds of services that have allowed DeFi to be ever more innovative and to go beyond the financial services that we knew until then.

And, before freeing itself and creating its own services and mechanisms, DeFi must first and foremost seek to reproduce classic financial services on the blockchain. The two services on which it focused are essentially lending services (here, we reproduce banking services by decentralizing them) and exchange services (here, we reproduce exchange platforms by decentralizing them) .

Why did you want to create AMMs?

It all starts with a certain frustration. We were talking about decentralized blockchain technology and we were not using decentralized platforms. We essentially went through centralized exchanges while at the same time promoting decentralization. In theory therefore, and not in practice.

For a long time, we simply replicated the mechanism of classic exchange platforms on the blockchain. Platforms like Binance or Kukoin are perfect examples. These are centralized platforms that therefore work with “order books”.

We even tried to create decentralized platforms with order books but there was such a lack of liquidity and traders that we couldn't really sell or buy (we didn't have a buyer or seller in front of us). This explains why many exchanges were decentralized from the beginning. closed their doors. There were no or very few market makers and this can be explained for different reasons. The platforms were not very pleasant and we were afraid of possible hacks. In short, there were not enough market makers and therefore not enough liquidity.

And we almost gave up.

However, the faults of centralized exchanges are numerous such as the fact that it is centralized (we are not the ones who hold our keys), possible security problems, higher fees, etc. And, we knew it.

We therefore needed decentralized exchanges which do not rely on a trusted third party but which are completely decentralized and which are executed via smart contracts. We therefore want to be able to exchange cryptocurrencies peer-to-peer, without the need for a trusted third party. Only, yes, in idea, it's sensational, but it's in practice that it doesn't work.

And this is where the idea of Automated market makers (AMM) appeared providing the ideal solution (or almost).

Automated Market Makers Explained

While on a centralized marketplace, market makers use their personal liquidity, there, on decentralized platforms, it is a computer program that will replace the order book.

Thus, users will be able to exchange (swap) their cryptocurrencies directly without going through an order book. This is replaced by liquidity pools which are executed by smart contracts.

Thus, each person can exchange their token using it directly in the liquidity pool. This allows us to be truly decentralized.

And to encourage people to provide liquidity, we offer them a portion of the fees generated by the transactions. So, in proportion to the liquidity it would provide.

Bingo! Win-win system!

You should know that there are different types of AMM with different functionalities but for our explanation, we will stick with the basic version.

There are AMMs with a constant function, AMMs with an average constant and even those with a Hybrid constant (as is the case for Curve). In fact, it is the mathematical equation that will govern and determine the price fluctuations of the tokens according to the liquidity pools.

Constant function Automated Market Makers are the most widespread AMMs

Typically, this is where AMMs have caused a sensation like Uniswap for example. This one, like the vast majority, is a constant function AMM. This simply means that the price for a pair of tokens is established based on available liquidity. Without going into details, this makes it possible to ensure a certain price constant.

But as the liquidity pool shrinks, prices increase exponentially. This well-known mechanism is what is called in the jargon, "slippage".

You still have a feature that allows you to see this slippage when you make a trade. You can even adjust the slippage tolerance.

Conclusion on MAs

Of course this allowed us to go further in DeFi and even make DeFi what it is. A rich disciple with continuous innovations and multiple and varied possibilities of reward. It is the AMMs which have enabled the growth of decentralized exchanges and in fact, with their own services such as Yield Farming for example.

That said, there are many drawbacks and limitations to MAID. Otherwise, it would be too good. Remember that we are still experimenting.

And, many things are done and theorized afterwards!

In any case, one of the biggest drawbacks of AMM is certainly what is called "Impermanent Losses".

In summary, it is when one of the two assets in the pair sees its value increase but the protocol does not update its value. Thus, the balance is not proven. That said, there are many people who know how to take advantage of these mechanisms and profit from them, but the liquidity provider is the one who is penalized.

Impermanent losses therefore represent the difference in value that has arisen over time between the tokens deposited in the AMM and those held in a wallet, for example....

Well, obviously, this is still really new and it's normal that there are adjustments. Also, there are now other versions of AMM (Automated Marker Makers) that seem even more powerful, such as Proactive Market Maker (PMM). The DODO protocol uses it for example.

We will see this in a future article…

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