Automated market makers (AMMs) are a type of decentralized exchange (DEX) that use algorithmic “money robots” to simplify the process of buying and selling crypto assets for individual traders. Unlike traditional order book systems where users trade directly with each other, AMMs facilitate trades directly through the AMM system.
Market makers play a crucial role in providing liquidity for tradable assets on exchanges that might otherwise lack it. They achieve this by buying and selling assets from their own accounts to make a profit, often capitalizing on the spread—the difference between the highest buy offer and the lowest sell offer. This activity enhances liquidity, reducing the price impact of larger trades.
Although other decentralized exchange designs exist, AMM-based DEXs have gained significant popularity. They offer deep liquidity for a wide range of digital tokens, making them a preferred choice for many traders.
Importance in DeFi Protocols
In the DeFi space, AMMs are indispensable for decentralized trading. They broaden access to a variety of assets, including niche cryptocurrencies, by eschewing conventional trading partners. Liquidity providers, by fueling liquidity pools, unlock trading venues, earn fees, and engage in yield farming.
This system democratizes trading, enhancing fairness and security. Noteworthy platforms like Uniswap and Balancer showcase AMMs’ contribution to DeFi’s evolution. Innovations such as proactive market makers (PMM) and virtual automated market makers (vAMMs) continue to extend AMMs’ capabilities and applicability.
| AMM Model | Function | Notable Examples |
|---|---|---|
| Constant Function Market Makers (CFMM) | Uses constant functions like x * y = k | Uniswap, Balancer |
| Curve AMMs | Combines constant product and sum formulations for lower price impact | Curve Finance |
| Dynamic Automated Market Makers (DAMM) | Uses Chainlink Price Feeds to dynamically adjust liquidity | Sigmadex |
| Proactive Market Makers (PMM) | Mimics traditional market-making to increase liquidity | DODO |
| Virtual Automated Market Makers (vAMM) | Enables synthetic asset trading with single token exposure | Perpetual Protocol |
What Are the Different Automated Market Maker (AMM) Models?
Automated Market Makers (AMMs) operate using various models, with Constant Function Market Makers (CFMMs) being the most prominent. These include constant product market makers, constant sum market makers, and constant mean market makers, popularized by protocols like Bancor, Curve, and Uniswap.
In these AMMs, the combined asset reserves of trading pairs must remain unchanged. Non-custodial AMMs pool user deposits within a smart contract that traders use for token swaps, trading against the pooled assets rather than directly with a counterparty.
Constant Product Market Maker (CPMM)
The constant product market maker (CPMM) was the first CFMM model to gain popularity, introduced by the AMM-based DEX Bancor. CPMMs operate based on the function x⋅y=kx \cdot y = kx⋅y=k, where xxx and yyy represent the quantities of two tokens, and kkk is a constant.
As the supply of one token increases, the supply of the other must decrease to maintain the constant product kkk. This creates a hyperbolic price curve, ensuring liquidity is always available but at increasingly higher prices, approaching infinity at both ends.
Constant Sum Market Maker (CSMM)
The constant sum market maker (CSMM) follows the formula x+y=kx + y = kx+y=k, creating a linear price function. This model is ideal for zero-price-impact trades but does not provide infinite liquidity. If the off-chain reference price between tokens diverges from 1:1, arbitrageurs can drain one reserve, leaving all liquidity in a single asset and destroying the pool’s balance.
Due to this vulnerability, CSMM is rarely used in AMMs.
Constant Mean Market Maker (CMMM)
The constant mean market maker (CMMM) supports pools with more than two tokens and allows for weighted distributions beyond the standard 50/50. The model ensures that the weighted geometric mean of each reserve remains constant.
For a pool with three assets, the equation is (x⋅y⋅z)1/3=k(x \cdot y \cdot z)^{1/3} = k(x⋅y⋅z)1/3=k. This flexibility enables variable exposure to different assets within the pool and facilitates swaps between any of the assets.
These AMM models each offer unique advantages and trade-offs, contributing to the diverse and dynamic landscape of decentralized finance.
How Automated Market Makers Work
Automated Market Makers (AMMs) are revolutionizing crypto trading by eliminating traditional order books in favor of liquidity pools and sophisticated algorithms. Understanding their functionality is essential for grasping their transformative impact on the decentralized finance (DeFi) ecosystem.
Liquidity Pools and Provision
Liquidity pools are the backbone of AMMs, enabling seamless token swaps. These pools require liquidity providers (LPs) to deposit pairs of tokens, thereby increasing market depth and facilitating efficient transactions. When a trade is executed, a fee is charged, part of which is distributed to the LPs as an incentive for providing liquidity.
This model democratizes market participation, encouraging a broad range of users to contribute to liquidity pools. This widespread participation is crucial for the growth and efficiency of DeFi platforms, as it ensures a steady supply of liquidity, which in turn, enhances market stability and reduces slippage during trades.
AMM Algorithms and Smart Contracts
The efficiency of AMMs is underpinned by their unique algorithms and the utilization of smart contracts. One of the most prevalent models is the Constant Product Market Maker (CPMM), exemplified by Uniswap. This model operates on a simple yet effective formula: x⋅y=kx \cdot y = kx⋅y=k, where xxx and yyy represent the quantities of two tokens in the pool, and kkk is a constant. This formula ensures that the product of the token amounts remains unchanged, automatically balancing prices in response to trades.
Smart contracts play a pivotal role in managing these transactions. They enforce the rules of the trading protocol, execute transactions, and distribute rewards to liquidity providers without the need for intermediaries. This automation enhances the transparency, security, and efficiency of the trading process.
Yield Farming and Liquidity Incentives
Yield farming is an additional mechanism that boosts liquidity in AMMs. In this process, liquidity providers earn governance tokens as rewards for their participation, further incentivizing the provision of liquidity. These tokens often grant holders voting rights on protocol changes, aligning the interests of the community with the platform’s governance and development.
Yield farming not only enhances liquidity but also increases the profitability of automated trading. By rewarding LPs with valuable tokens, DeFi platforms can attract more participants, ensuring robust liquidity pools and more stable trading environments.
Advantages of Automated Market Makers (AMMs)
Automated Market Makers (AMMs) offer numerous advantages that enhance the trading experience in the decentralized finance (DeFi) ecosystem.
Decentralized Trading
AMMs facilitate decentralized and trustless trading, eliminating the need for intermediaries. Traders don’t need to sign up, disclose sensitive information, or rely on a third party to manage their funds. All that’s required is a self-custody wallet, ensuring privacy and control over assets.
Enhanced Liquidity Access
AMMs provide traders with easy access to a wide array of trading pairs, including those not available on traditional exchanges. Liquidity pools in AMMs enable the trading of multiple assets simultaneously, supporting more complex trading strategies and improving market depth.
Lower Fees
Centralized exchanges often impose high fees as their primary revenue source. In contrast, AMMs charge significantly lower fees, making trading more cost-efficient. For instance, Uniswap charges just a 0.3% fee per trade, which is considerably lower than most centralized exchanges.
Automatic Pricing
AMMs use algorithmic pricing, reducing the pricing risks associated with centralized exchanges, such as frontrunning asset releases. This automatic pricing mechanism ensures fairer and more transparent trading conditions.
Greater Flexibility
The open-source nature of AMMs allows for seamless integration into various DeFi protocols, including lending and borrowing platforms. This flexibility enables the creation of diverse financial products and services, enhancing the overall DeFi ecosystem.
Problems with First-Generation AMM Models
First-generation Automated Market Makers (AMMs) face significant issues, including impermanent loss and low capital efficiency, which affect both liquidity providers and traders.
Impermanent Loss
Impermanent loss occurs when the value of tokens deposited in an AMM changes compared to simply holding those tokens in a wallet. This happens when the market price of tokens within the AMM diverges from the broader market prices.
Since AMMs don’t automatically adjust their exchange rates, they rely on arbitrageurs to buy underpriced assets or sell overpriced assets until the AMM’s prices align with the market. However, the profit arbitrageurs gain comes at the expense of liquidity providers, leading to losses for the latter.
Low Capital Efficiency
Traditional AMM designs require vast amounts of liquidity to achieve the same level of price impact as order book-based exchanges. This inefficiency arises because a significant portion of AMM liquidity only becomes available when the pricing curve turns exponential.
Rational traders typically avoid these extreme price impacts, leaving most of the liquidity unused.
Liquidity providers in AMMs lack control over the price points offered to traders, leading to the term “lazy liquidity.” This liquidity remains underutilized and poorly provisioned.
In contrast, market makers on order book exchanges can precisely control the price points at which they buy and sell tokens, achieving higher capital efficiency. However, this efficiency comes at the cost of requiring active participation and constant oversight of liquidity provisioning.
How AMM Models Are Being Improved
Innovative projects are addressing the limitations of first-generation AMMs by introducing advanced models such as hybrid automated market makers, dynamic automated market makers, proactive market makers, and virtual automated market makers.
These new designs enhance liquidity provision, reduce price impact, and improve overall market efficiency.
Hybrid CFMMs
Hybrid Constant Function Market Makers (CFMMs) combine multiple functions and parameters to achieve specific behaviors, such as adjusted risk exposure for liquidity providers and reduced price impact for traders.
Curve AMMs, for instance, utilize a stableswap invariant formula that merges the properties of both CPMM and CSMM. This approach creates denser liquidity pockets, lowering the price impact within a specific trading range. The resulting curve is mostly linear, becoming parabolic only when the liquidity pool is stretched to its limits.
Curve’s design allows for low-price-impact trades between tokens with relatively stable exchange rates, such as stablecoins. Liquidity providers benefit from more efficient capital use, earning higher aggregate fees despite lower fees per trade.
Meanwhile, arbitrageurs profit from rebalancing the pool, ensuring continuous market equilibrium. Curve has also extended support to more volatile token pairs while maintaining concentrated liquidity.
Dynamic Automated Market Maker (DAMM)
Sigmadex employs a dynamic automated market maker (DAMM) model that leverages Chainlink Price Feeds and implied volatility to dynamically allocate liquidity along the price curve.
This model adapts to changing market conditions by concentrating liquidity near the market price during low volatility and expanding it during high volatility. This dynamic allocation improves capital efficiency and protects traders from impairment loss, ensuring a more resilient market maker.
Proactive Market Maker (PMM)
DODO utilizes a proactive market maker (PMM) model that mimics traditional human market-making behaviors seen in central limit order books. By using accurate market prices from Chainlink Price Feeds, DODO proactively adjusts the price curve of each asset in response to market changes.
This increases liquidity near the current market price, facilitating more efficient trading and reducing impairment loss for liquidity providers. The PMM model enhances liquidity provision and optimizes trading conditions.
Virtual Automated Market Makers (vAMM)
Virtual automated market makers (vAMMs), such as those used by Perpetual Protocol, minimize price impact, mitigate impermanent loss, and allow single token exposure for synthetic assets. vAMMs utilize the same x*y=k constant product formula as CPMMs but operate without a traditional liquidity pool.
Instead, traders deposit collateral into a smart contract to trade synthetic assets, gaining exposure to various crypto assets efficiently. However, traders must be cautious, as holding an open position in a synthetic asset can result in collateral liquidation if the price moves unfavorably.
