When you exchange digital assets with another trader, you do so on the basis of confidence. Do you recall the person who sold his pizza for 10,000 Bitcoins? Before sending Bitcoins, he had to make sure that the person to whom he was sending BTC would not take his money.
One way to conduct such trading is through Bitcoin forums and IRC networks, where you can rely on an individual's credibility score. Typically, such trading takes place on peer-to-peer (P2P) trading sites. However, there are several threats associated with these networks. After winning confidence, there's a chance the person will betray you.
The need for trusting credibility scores vanished with the creation of exchanges like Coinbase and Mt Gox. Individual traders can deposit money into a centralized account and exchange with each other. However, as with Mt Gox, such trading entails custody risks.
As the number of digital assets grew, these centralized exchanges became liquidity gatekeepers. NFTs, personal tokens, and other on-chain representations of value can increase the amount of digital assets. In this situation, having an infrastructure that allows for the exchange of one asset for another without the intervention of a third party is important. It is at this point that automated market makers and liquidity pools enter the picture.
Automated Market Makers
Automated Market Makers (AMMs) are a type of decentralized exchange protocol that uses a mathematical formula to determine a token's price. Each protocol has its own formula. Balancer, for example, uses the formula x*y=k, where x is the value of one token in the liquidity pool and y is the value of the other. Since k is a constant in this formula, the pool's total liquidity will always be constant.
Different AMMs use different formulas, but they all have one thing in common: they all use algorithms to calculate prices. Smart contracts are used by AMMs as a maker in exchange transactions. AMM's definition is similar to ShapeShift and Changelly's facilities. The only difference is that liquidity pools replace the company's savings. In 2017, the first AMM was developed. It was Bancor, and today we have Uniswap, Curve, Kyber, and Balancer, among other market makers.
How does it work?
A market maker that is automated operates in a similar way to an order book exchange. Since all you have to do with AMM is communicate with a smart contract that "makes" the market for you, you don't have to trust your fellow trader.
An automated market maker can be thought of as a peer-to-contract transaction. In most cases, the exchange is conducted between the user and the contract. A formula is used to calculate the price of an asset. Although no counterparties are needed, someone should be in charge of creating the market.
Liquidity Pools
Liquidity suppliers contribute to the pool's liquidity. A liquidity pool is a large sum of money that traders can use to exchange with. LPs that provide liquidity to the pool are rewarded for the trades that take place in their pool. The protocol will determine the incentives that the LPs will receive.
The slippage that occurs in each trade is the primary reason for providing liquidity to the pool. The price was calculated using a parabola-like formula. It means that the shape of a parabola depicts low slippage for small orders and exponentially increasing slippage for large orders.
Different AMM designs would have different slippage issues. You may want to buy all of the ETH in the ETH/DAI pool on Uniswap, for example. You should pay a higher premium for each additional ether in this situation. x*y=z is the formula used here. The equation would not make sense if one of the terms (x or y) is zero. It means that if the pool has no ETH or DAI, the equation will fail and you will be unable to purchase it from the pool.
Impermament Loss
If you deposit a certain amount of tokens in a pool and the price ratio changes after you deposit them, you have suffered an impermanent loss. The amount of loss is determined by the magnitude of the transition. It means that if the price change is significant, the loss would be significant as well. However, if the price ratio is small, the loss would be small as well. Stablecoins and wrapped coins benefit from Automated Market Makers.
Impermanence assumes that the losses will be recovered if the assets return to the same values as they were at the time of the initial deposit. If you withdraw your funds at a different price ratio than when you invested them, on the other hand, the losses are irreversible.
Advantages of AMMs
AMMs are decentralized because they do not use gatekeepers to keep projects or users out, and they do not need any central authority.
The AMM protocols do not enable users to build specific accounts or perform any KYC tests, so they are permissionless. To connect with the protocols, the user only needs a wallet address.
There are no listing fees or admission requirements on the AMM Decentralized Exchanges since everyone can build a liquidity pool for a token.
These DEXs provide intuitive user interfaces.
Disadvatanges of AMMs
AMMs are vulnerable to hacks and bugs, and users can lose money as a result of complicated smart contract interactions.
Traders make their plan known to the rest of the planet. It helps the front-runners to get their orders first and exploit legitimate customers.
Arbitrage traders are important in AMM to correct asset pricing, but on many platforms, they result in a impermament loss.
Conclusion
AMMs (Automated Market Makers) are a must-have in the DeFi space. Markets can be created quickly and easily by anyone. AMMs have a major impact on the cryptocurrency industry. AMMs are still in the early stages of production. There are many AMMs with sleek designs, such as Uniswap, Curve, and PancakeSwap, but they have minimal features and are working to improve the platform. You should expect to see a variety of groundbreaking AMM designs in the future. In the end, each DeFi consumer would benefit from lower transaction costs, less friction, and increased liquidity.
Person sold his pizza for 1000 bit coins