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Automated Market Makers: What are they, an in-depth analysis of what are they, and how it helps in crypto-trading?

07 Jun 2022 By : Sudeep Saxena
Southeast Asia’s Lar

Have you ever wondered how decentralized exchanges (DEX) handle trading and price discovery? A DEX, unlike traditional exchanges, employs an automated market maker (AMM) to provide a more fluid trading system that straddles the line between autonomy, liquidity, and automation.  This article will let you learn more about automated market makers and how they work to fuel decentralized exchanges.

Market Making: What Is It?

Before we go into the mechanics of AMMs, it's crucial to understand how market makers work together in the financial world.

Market making, as the name indicates, refers to the act of determining asset values while also providing liquidity to the market. A market maker, in other words, creates liquidity for a financial asset. It must find a mechanism to satisfy the selling and purchasing orders of traders, which has an impact on the asset's pricing.

To enable Bitcoin trades, a Bitcoin exchange, for example, utilizes an order book and an order matching mechanism. The order book keeps track of and displays the prices at which traders want to purchase or sell Bitcoin.

It's worth noting that the equation presented as an example is simply one of several formulas for balancing AMMs. Balancer's protocol uses a more complicated algorithm that allows it to pool up to eight tokens in a single pool.

While there are many different methods for AMMs, such as Uniswap and Balancer, they all require liquidity to work correctly and avoid slippages. As a result, these protocols reward liquidity providers by allocating a portion of the commission produced by liquidity pools and governance tokens to them. In other words, when you give funds to manage liquidity pools, you collect transaction fees.

This will put new introspection to speculative currency and bring about new revolves around altcoins other than the major 10 coins to look up to.

After you stake your fund, you'll get liquidity provider tokens, which represent your portion of the deposited liquidity.

Impermanent Loss is a term that refers to a loss that is Although AMMs provide considerable returns to LPs, they are not without risk. Impermanent loss is the most prevalent. When the price ratio of assets in a liquidity pool changes, this phenomenon occurs. LPs who have placed funds in the concerned pools will suffer a temporary loss. The greater the price ratio change, the greater the loss.

This loss, however, is said to as temporary for a reason. It is still feasible to lessen this loss if you do not withdraw deposited tokens when the pool is suffering a pricing ratio adjustment. When the values of the tokens return to the original value when they were placed, the loss is gone. Those that withdraw money before the prices return will be penalized.

Those that withdraw money before the prices reverse will lose it forever. However, the money gained through transaction fees may be sufficient to compensate for such losses.

Conclusion

AMMs have shown to be creative solutions for facilitating decentralized exchanges in recent years. In this time, we have witnessed the emergence of a slew of DEXs that are driving the ongoing DeFi hype. While this does not mean that the approach is flawless, the advancements recorded in the last 12 months are indicative of the several possibilities that AMMs provide. It remains to be seen where we go from here.



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