LeoGlossary: Automated Market Maker (AMM)

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*Automated Market Makers AMM) are a part of decentralized finance (DeFi). These are decentralized exchanges (DEX) which allow for buyers and sellers of cryptocurrency to have liquidity in the assets they are trading.

Not all DEX are AMM since there are other ways to secure liquidity.

Essentially a trade bot is used which is run based upon algorithms. This can be thought of as a "money bot".

The first exchange to use this was Uniswap in 2018.

Other AMM:

Kyber Network Balancer Curve Finance

Replaces Order Book

Market makers are a part of centralized exchanges (CEX). In traditional finance, TradFi, the best solution is to have a liquid market with plenty of professional buyers and sellers. This makes it easy for an exchange to match a buy with a sell order.

What about times liquidity is low? Obviously, spreads widen as the bid-ask spread out. Here is where a market maker can step in and facilitate the trade. Firms that act as money makers ultimately are securities warehouses, being able to step in when needed.

Financial institutions that act in this capacity allow the exchange to ensure there is a counterparty for trades. The transactions go through because the market maker is doing what is described, making the market.

As we can see, there is a financial intermediary involved. These exchanges also operate on using an order book where all offers, either to buy or sell, are placed. Some DEX utilize this also yet AMM operate differently.

The AMM replaces the order book using autonomous protocols. These are programmed through smart contracts which are tied to liquidity pools. This is where the liquidity is derived from.

Liquidity Pools

Automated Market Makers access pre-funded pools of coins or tokens. They generate liquidity by incentivizing individuals to stake their assets. In exchange, investors get a return based upon, usually, the transaction fees. The cryptocurrency is placed in the LP (smart contract) which the AMM basically trades against.

This can be a fantastic opportunity for investors. It is not without risk. Impermanent loss is something that LP holders have to be mindful of. Cryptocurrency is volatile so pairs in a pool can see a massive pullback in a short period of time.

A liquidity pool is filled with equal amounts of both assets, based upon USD values, upon entry. The movement of each is not going to be in tandem so we can see the value of the pool skew one way or another.

AMMs access the assets in the pool and use this to fill orders. When an individual places a buy order through a DEX such as Uniswap, the tokens are not removed until there is a match. This is what the AMM handles.

Unlike traditional markets where market makers are high net worth individuals (or companies), anyone can get involved in a liquidity pool. There is no minimum and people can stake as much (or little) as desired.

Investors has a piece of the total pool. As assets are moved in and out by the AMM, the balance is always shifting. There is the added factor of investors are continually entering and exiting.

It is possible to see discrepancies within the pool especially if a large transaction takes place. When this occurs, there is an arbitrage opportunity that can be leveraged. Traders will enter and close the gap that was created.

All of this is based upon, from the AMM end of things, mathematical formulas.

Yield Farming

Investments in liquidity pools can be termed yield farming. An investor is placing tokens in the pool with the expectation of a return. This is a passive process where one is not focused upon speculation. While that is part of the mindset, the entry into the pool is to get a return.

If the pool is heavily traded, the transaction fees will add it. This is distributed to the LP holders, providing yield. It is a return that is exclusive of the price either pair.

We can see how the speculation side of the equation can be removed if we have a pool where both pairs are stablecoins. Under this scenario, the investor is not seeking to have the price of either asset move up. There also is less risk that it will move down. The ultimate goal is to garner yield out of the investment.

Managing risk, especially how it pertains to impermanent loss is vital. Yield can sometime compensate (reduce) the hit to the price of the asset if one (or both) head down. Naturally, if the assets were held outside the pool, it is likely the individual would see a similar decline in the value in the wallet.

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