Automated Market Makers (or AMMs) keep the DeFi ecosystem liquid 24/7 as they rely on a decentralized community of liquidity pools and liquidity providers, replacing traditional order books.
What are Automated Market Makers?
A fully decentralized exchange known as an Automated Market Maker (AMM) relies on liquidity pools and liquidity providers rather than buyers and sellers like conventional financial exchanges. An algorithm used to price the tokens in the liquidity pools automates price changes in response to market demand while also minimizing slippage. AMMs are always on.
What are Liquidity Pools?
Liquidity pools are used by automated market makers (LPs). In order to give traders liquidity, LPs are two distinct tokens that are tied under a smart contract. The tokens included in the LP must have an equal total value, for instance, in the DAI/ETH pool, 50% DAI and 50% ETH. This is so that AMMs can price the assets in LPs using a straightforward mathematical formula.
How do liquidity pools work?
The above may sound overwhelming, but it’s actually simple. The most common formula that Uniswap and other AMMs use is x*y=k, where x and y represent unique tokens, and k remains constant. When the balances of x and y changes, they will need to adjust to maintain k. Otherwise, this will create an arbitrage opportunity. Arbitrage is when the price of an asset is different between two or more markets. By trading between markets, you can profit from the price differences.
When a trade happens in a LP, you are increasing the supply of one token to exchange for another. If, for example, you are buying 1 ETH(x) from the Uniswap DAI/ETH pool, the amount of ETH in the pool is reduced, increasing DAI(y). So, to keep k constant, ETH will become marginally more expensive in DAI so the LP is rebalanced.
If the example involved more ETH, then the LP would need to adjust even more. That is why liquidity pools rely on liquidity providers to strengthen the trading pair, as more liquidity in the LP means less slippage.
What is a Liquidity Provider?
Anyone who wants to contribute their tokens to a liquidity pool is a potential liquidity provider. They will be compensated with tokens for the liquidity pool that correspond to their percentage of the pool. Traders pay a tiny access charge each time a deal occurs in a liquidity pool. The benefit for paying that fee is subsequently dispersed to liquidity providers in accordance with their proportionate share of the liquidity pool.
What is Impermanent Loss?
Giving an AMM liquidity puts you at risk of "impermanent loss." This means that when you take money out relative to what you put in, you lose money. The price of the assets in the pool can change, resulting in impermanent loss. You are more vulnerable to loss the more they alter.
The loss is temporary because the token distribution within the LP can return to its original state. But if you leave when one token's worth has drastically altered from when you entered compared to when you joined, the loss is irreversible.
What are Gas Fees
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How do you redeem your liquidity pool tokens?
It is necessary for a liquidity provider to burn (delete) their LP tokens in order to obtain any underlying assets that may have changed.
Examples of AMMs
1) CURVE : an AMM that uses a different algorithm than Uniswap to trade tokens with comparable values, such as wrapped ETH and ETH, for example.
2) BALANCER : Users can construct their own liquidity pools with up to 8 tokens that have different weights, making it a self-weighted portfolio AMM.
3) KYBER : allows anyone to swap tokens without needing to use an exchange
A full list of AMMs can be found on CoinGecko.
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