Automated market makers are algorithmic entities that facilitate liquidity in electronic markets without traditional buyers and sellers. First developed in the 1990s, the concept of automated market making is most often associated with the decentralized finance (DeFi) ecosystem today.
Automated market makers or AMM play an important part in cryptocurrency trading as they make it easier to trade digital assets. AMM crypto trading involves creating a marketplace in which traders can buy and sell digital currencies. That means cryptocurrency trades can take place outside the confines of the traditional buyer-seller market, on a decentralized exchange.
In terms of volume, AMM crypto exchanges process billions of dollars in transactions every day. When measured by market capitalization, some of the biggest AMM coin and AMM token exchanges include Uniswap (UNI), PancakeSwap and SushiSwap (SUSHI).
If you’re interested in trading cryptocurrency or you already own crypto in your portfolio, read on to learn how automated market making actually works.
Understanding AMM
To understand automated market makers in the context of cryptocurrency, it helps to understand what a market maker is in general. In the stock market, a market maker is a firm that buys or sells stocks at quoted prices. Market makers facilitate liquidity and influence pricing for publicly traded securities.
Automated market makers play a similar role in the cryptocurrency markets, helping traders invest in crypto. But there are a few things that set AMM exchanges apart from traditional market makers. Specifically, they differ in two important ways:
• How trading transactions take place
• Asset pricing
Rather than relying on the traditional market of buyers and sellers, automated market making utilizes liquidity pools of different types of cryptocurrency, so that they can always offer a quote to a trader. A liquidity pool is a collection of tokens or cryptocurrencies locked in a smart contract. A smart contract is a computer program that operates within the blockchain to automatically execute transactions.
Liquidity pools replace the order book in electronic trading. An order book is a digital list of buy and sell orders for a specific security or asset. These order books are organized by price level so that it’s easy to see the price at which a given security or asset is trading.
Algorithms determine the prices for assets within liquidity pools. That means everyone gets the same price when using an AMM to buy crypto.
How Automated Market Making Works
Automated market making allows crypto traders to make trades independently of one another on a decentralized exchange. What’s required is at least one trader who has cryptocurrency they want to buy or sell. So, if you have crypto you want to sell, for instance, you could do so through a smart contract.
This smart contract makes the market, or connects your transaction with a buyer. A key feature in decentralized finance is that the trades take place between users and contracts, not users and other users. Instead of an order book, the AMM exchanges use liquidity pools, and the exchange’s algorithm sets the asset price.
Liquidity providers also play a part in facilitating AMM crypto transactions. A liquidity provider is a crypto term used to describe a user that deposits tokens into a liquidity pool. AMMs incentivize liquidity providers by giving them tokens that represent a share of the liquidity pool they own. They can exchange, transfer, or stake these tokens.
AMM Crypto Trading Example
Assume that you want to buy Ethereum through Uniswap, which runs on the Ethereum blockchain. You plan to buy the tokens using another cryptocurrency. We’ll use Tether as an example.
When you go to the Uniswap website and begin the swap, an algorithm will calculate a price quote for you, based on how your trade will impact reserves in the liquidity pool. Once you approve the swap, a smart contract will deposit your Tether tokens into the liquidity pool and draw the equivalent amount of Ethereum out of the pool.
The algorithm that AMM coin and AMM token exchanges use to calculate prices for crypto swaps can use a formula like the x * y = k model. In this formula, x and y equal the amount of assets in the liquidity pool, while k is the total amount of pool liquidity.
That means that when you buy one type of cryptocurrency from the pool that shifts the balance of the pool’s assets. The less of one asset there is in the pool to keep the balance, the higher the price of that asset becomes as you buy more of it.
Pros and Cons of AMM Crypto Exchanges
Automated market making is relatively new in the DeFi landscape, but AMM exchanges may see increased popularity as demand for cryptocurrency trading grows. For crypto traders, AMMs can offer both advantages and disadvantages. It’s important to understand what’s good about automated market makers — and where they may fall short.
Pros
There are several benefits to automated market makers:
• Access. Since automated market makers operate within a decentralized exchange, they make cryptocurrency trading accessible to a wider range of investors. Anyone with a crypto wallet can trade digital currencies with AMM coin exchanges.
• Liquidity. AMMs can also offer increased liquidity over traditional market makers as long as they have traders willing to act as liquidity providers.
• Reduced slippage. Slippage is the gaps in pricing that can occur when there’s poor liquidity and poor trading volume. Automated market makers can help create more liquidity, which helps reduce slippage.
Cons
There are also a number of drawbacks to using an AMM.
• Security. Cryptocurrency trading poses unique security risks, since these transactions take place over a decentralized exchange. While AMMs can implement security measures, there’s no guarantee against a hacker making off with your crypto assets.
• Impermanent loss. Impermanent loss occurs when the price ratio of deposited tokens changes once those tokens join a liquidity pool. The greater the change in pricing the greater the impermanent loss.
• Slippage risk. While automated market makers can help to reduce slippage during periods of high liquidity, slippage risk still exists. The potential for pricing differences increases when crypto trading volumes are higher.
| AMM Pros | AMM Cons |
|---|---|
|
• AMMs make crypto trading widely available for more investors • Automated market makers can offer enhanced liquidity • Price slippage may be reduced when liquidity is high |
• Security threats may be greater with a decentralized exchange • Impermanent loss can occur when new tokens are deposited • Price slippage may increase when trading volume is high |
The Takeaway
AMM is one avenue the crypto traders might consider when building their portfolio. However, it’s also possible to get started investing in cryptocurrency without using automated market makers.
When you open an investment account on the SoFi Invest platform, you can trade a number of cryptocurrencies, including Bitcoin, Ethereum, Litecoin, Bitcoin Cash, Ethereum Classic, and more. Crypto trading is available 24/7 and SoFi secures your account to keep it safe from hackers.
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