Creating your own crypto market via AMMs minus the manipulation
Automated Market Makers were invented to replace traditional order books that were made by human hands that manually initiate trades to enliven market liquidity. Traditional market makers were often accused of market manipulation due to occurrences of price slippage and latency. AMMs became a buzz when it was first implemented in the 1990s by the Lehman Brothers and ATD as it served as a welcome solution to all the headaches that human market makers were causing. Today, AMMs are also introduced as featured systems on decentralized blockchain exchanges.
Decentralized exchanges (DEXs) that implement an automated market maker (AMM) apply liquidity pools instead of the traditional order book, pre-funding assets of both the trading pair on-chain. Users, called liquidity providers (LPs), who supply funds on the liquidity pool accumulate passive incomes through trading fees based on percentages of their deposits.
Liquidity pools are important for AMMs since the more liquidity is provided in the pool, the less there is for slippage to occur on large orders, adding more volume in the process. However, since pricing is determined by an algorithm, slippage cannot be avoided especially when the ratio variant between tokens in the liquidity pool changes by a wide margin after a trade has been made. This is called impermanent loss.
As we have said, impermanent loss occurs when the ratio variant of deposited tokens in the liquidity pool has changed by a considerable margin after a trade. The change is equivalent to an impermanent loss. It is important to note, therefore, that AMMs can be maximized with coin pairs that are close to the same value, like stablecoins. Impermanent loss is negligible when token pairs fair in range. As there is no guarantee to the similarity between token values owing to the volatility of the crypto market, liquidity providers can just hold on to their tokens until more favorable winds blow their way before entering the liquidity pool. But whatever happens, risks can be mitigated by accruing fees from trades, or if prices revert back when deposits were made.
AMMs in the DeFi Space
Kyber Network worked on the first AMMs in the early part of 2018, introducing liquidity pools that are either deployed by the project team or professional market makers. However, their pools are limited and not open to anyone. They can set up the token price on the liquidity pool via external oracles, or it is determined automatically by smart contracts upon the setup. These systems give market makers control of the liquidity pool during market fluctuations.
Uniswap is recognized as the first decentralized AMM in its truest sense when it entered the market in the latter part of 2019. Uniswap empowers anyone to deploy a liquidity pool in its protocol, thereby enabling others to contribute liquidity in the ecosystem. The unique thing about Uniswap’s DeFi character is that its price in the smart contract cannot be controlled or configured. Instead, the tokens’ pool price is only determined by the balance ratio between the token pairs in the pool.
Balancer is the latest AMM to enter the market. Added to its functions similar to Uniswap are other unique features that make it more than another liquidity pool.
Curve is another DeFi newcomer belonging to Class 2020. Its AMM protocol’s liquidity pools are exclusively generated by the project’s admin where anybody can supply funds to. Curve’s distinction among the others is that it only supports stablecoins. This feature allows it to complete large orders with low slippage due to the high concentration of deposits in its limited amount of pools.
Automated Market Makers are standards of the DeFi space, offering opportunities for both traders and liquidity providers. Traders can experience instant trades at market price. Liquidity providers can earn from trading fees. AMMs can practically enable anyone to efficiently create markets that make them an invaluable piece of technology in the cryptocurrency market.
Decentralized exchanges previously mentioned offer different AMM designs. Professional market makers can go along with Kyber Network while the everyday crypto user might be at home with either Uniswap or Balancer. Curve may be attractive to those looking for steady rates. Whatever the case, be vigilant in monitoring your pool and seek market conditions that work in your favor.