What Is an automated market maker or AMM? This is a concept that may be new to some crypto enthusiasts and while the explanation may seem like a bit of a deep dive into computing and less like something you would associate with investing in or trading crypto, AMM is a type of investing algorithm worth learning more about as we’ll see below.
Why Use An Automated Market Maker?
We’ll define the nuts and bolts of AMM below, but one question on the minds of some–why bother with AMM when there are exchanges like Coindesk? It helps some to know what the AMM is meant to improve or replace. As mentioned above, in this case, it’s the centralized exchange itself.
When you buy, sell, or trade Bitcoin or Ethereum on a centralized exchange, you have an “ecosystem” of traders and those placing trade orders, and the buyers and sellers are connected on the centralized network.
It gets a bit more complicated for the newcomer to crypto when you learn that price points become an important part of this process.
You may have someone trying to sell a virtual currency for X amount of dollars; the trick for the centralized exchange to play matchmaker to find a buyer willing to purchase at that price point. The exchange is the middleman. Sound familiar? The faster the transactions are executed, and the less hassle-free those transactions are made, the better.
When you put an order in to buy a coin and there is a technical issue that causes a delay, the price of your order might fluctuate in the meantime. That could, depending on how large the change is and how much volume you are buying or trading, result in the purchase of investments with a different value than you were expecting. If your order being executed relies on the work of a human, this delay is more likely than when relying on automation like AMM.
What happens if you get rid of the middleman and use an approach that does not require the immediate presence of a buyer but still gets the job done AND takes steps toward minimizing that problem? That is a crude way of explaining AMM.
Automated Market Maker technology eliminates the middleman and requires no buyer on the other end. That sounds impossible to an outsider to crypto–what is the missing detail you need to better understand this process?
What Is An Automated Market Maker (AMM)?
An automated market maker is designed to facilitate the sale or exchange of crypto on a “trustless” level using software instead of human intervention. That means no order books, no exchange or network to depend on for the system to work.
There doesn’t even have to be a buyer presently waiting for the seller to move her coins. The software does the heavy lifting of putting buyer and seller together via a “liquidity pool” designed to facilitate trades or sales without necessarily having to have a buyer specifically in mind. The pool represents the number of coins available to be purchased–but how does the crypto get in there in the first place?
These pools are where virtual currency holders pledge some of their currency to the pool in order to maintain liquidity in the market (and earn rewards for doing so). The community keeps the pool stocked up with currency, those investors get their rewards when it is sold. The sales are facilitated by AMM matching buyers with the crypto in the pool.
Some crypto blogs refer to this as an automated liquidity protocol, which might not sound like much more than jargon at first. But the tech itself is easy enough to conceptualize without being a programmer.
An excellent example can be found in the decentralized exchange protocol known as Uniswap. This protocol facilitates trades without a third party and is decentralized thanks to the use of these liquidity pools.
Investors are known as liquidity providers. In exchange for participating in the pool, you potentially earn a fee or a payment based on the transactions that happen within these pools. The type and amount of these rewards will vary depending on the platform utilizing AMM.
A token or coin’s liquidity basically refers to how easy it is to buy and sell that coin or token. If there is a seller’s market, where demand is high and supply is low, that affects liquidity.
The same is true when there are more sellers than buyers–the liquidity issues there reflect the glut of coins or tokens compared to the willingness to buy. AMM helps to manage these issues via the liquidity pool.
Users are given a financial incentive to contribute to the pool; in a centralized exchange, liquidity may come from a financial institution or a pool of investors.
The centralized exchange is subject to a problem called slippage; this happens when you place an order for a coin or token and due to any number of variables some time delays occur between the order and fulfillment of it.
Slippage happens when the price changes in the meantime. When the investor gets “burned” by slippage, they have experienced one of the problems inherent in the centralized system that AMM technology proposes to eliminate (or at least reduce) via liquidity pools and the automated nature of AMM.
The more liquid any given pool is, the lower the risk of slippage, which is a major incentive for some investors using these resources. One thing about AMM that is appealing to some investors?
You don’t have to be a high-roller-type investor in order to contribute to a liquidity pool. In centralized exchanges or more traditional finance markets, those who contribute liquidity must have substantial assets. But with AMM, whatever you bring to the table counts when it comes to increasing the availability of the crypto.
The Future Of AMM?
Uniswap, which we discussed above, is described as being the first decentralized finance platform to use AMM and do it successfully. That was in 2018, which means the technology may be subject to further refinements, improvements, restrictions, and one day possibly even federal regulation.
The very nature of crypto investing makes it subject to sudden shifts in technology, in legality, and other areas. Today’s AMM algorithms may easily be replaced with newer, smarter, and more robust versions much in the same way that proof of work could be overtaken by proof of stake and similar technical issues in the crypto world.
It’s smart to stay on top of these technical developments as they can and often do directly affect your options and choices for investing in crypto or using DeFi.
Joe Wallace has covered real estate and financial topics, including crypto and NFTs since 1995. His work has appeared on Veteran.com, The Pentagon Channel, ABC and many print and online publications. Joe is a 13-year veteran of the United States Air Force and a former reporter for Air Force Television News.