Automated Market Making in Crypto

Automated market making is an integral part of the success of the DeFi space, revolutionizing traditional finance systems by introducing massive levels of flexibility in the domain of crypto trading.

Blockchain technology's potential for cryptocurrencies is still yet to be fully exploited. Automated market making (AMM), one of the crypto's decentralized finance (DeFi) sector entrants, has been hailed for its potential to revolutionize traditional finance systems. To understand the automated market making in crypto, you need to know about conventional market makers.

#What Is a Market Maker?

As the name implies, a market marker is involved in making the market for an asset. These individuals and institutions offer liquidity to enable investors to sell or purchase assets that are close to a publicly listed price. Instead of looking for a buyer interested in the exact volume of an asset you want to sell (and sellers when you want to buy), market makers step in, buying and selling, regardless of the volume.

By providing liquidity, market makers match the buy orders and sell orders of investors, making it easier for the execution of trades. To gain profit and cover the risk involved in both buying and selling an asset simultaneously, market makers charged fees called spreads.

However, this critical process of providing liquidity for assets has been automated with the rise of blockchain technology and smart contracts. Now that you know the role of a market maker, let’s delve into the concept of Automated Market Making (AMM).

#Automated Market Making

The quest to eradicate all intermediates involved in crypto trading is one of the key factors that led to the development of automated market making. The order matching systems and order books of traditional market making are replaced with autonomous protocols called AMMs.

Instead of using order books, assets are priced according to a pricing algorithm under automated market making. Smart contracts are self-executing programs that facilitate the instantaneous buying or selling of crypto in decentralized exchanges (DEXs).

In 2018, Uniswap became the first decentralized platform to successfully utilize an AMM system. All DEXs are now built using an automated market maker.

The Automated Market Maker can thus be described as a protocol that automates digital asset trading without the need for authorization before it determines the liquidity of the crypto coin. Under AMMs, trades are executed automatically using liquidity pools to substitute buyers and sellers.

#How Do Automated Market Makers Work?

An automated market maker works similarly to an order book exchange of traditional market making in that there are trading pairs, like BTC/USDT. However, you do not need a counterparty interested in buying the exact amount of BTC/USDT you want to sell.

In automated market making, you interact with a smart contract on a blockchain that "makes" the market for you, eliminating the market makers of traditional financial markets. For example, if you want to sell your Bitcoin for USDT worth $1,000, you do not need to find a counterparty ready to sell his $1,000 worth of USDT for Bitcoin.

When you want to sell your Bitcoin for USDT, the AMM automatically matches the amount you want to sell from its liquidity pool. Although there are no counterparties like in traditional market making, the liquidity in the smart contract still has to be provided by users called liquidity providers (LPs).

Automated Market Making also holds an inherent risk similar to traditional market making. When large orders are placed in AMMs and a sizable amount of a token is removed or added to a pool, notable discrepancies may appear between the asset's price in the pool and its market price. Discrepancies can be taken advantage of by arbitrage trading in crypto.

#What Are Liquidity Pools?

A liquidity pool is a pool of tokens locked in a smart contract; therefore, liquidity providers (LPs) add funds to the liquidity pools. In reward for locking up their funds to be used as liquidity, liquidity providers are given a fixed amount of the fees charged on each transaction.

Other portions of the transaction fees are returned to the liquidity pool to further increase the value of your tokens and aid in growing the pool.

#Final Thoughts

AMM is an integral part of the success of the DeFi space, revolutionizing traditional finance systems by introducing massive levels of flexibility in the domain of crypto trading. Although AMMs are in their early stages, they already enable anyone to create markets seamlessly and efficiently.