What Is An Automated Market Maker and Why Does It Matter to DeFi?

Introduction

An automated market maker (AMM) is a system of simple algorithms that is always willing to quote you a price between two assets. AMMs were used for the first time in the early 90s on the Shearson Lehman Brothers exchange and ATD. The goal was to increase liquidity and to fight market manipulation. These algorithms solved many issues caused by human bias, such as price slippage or delays in the price discovery mechanism. Currently, in DeFi, exchanges that did not rely on a third-party service began to implement automated liquidity providers’ systems.

So, let us sum it up for you. AMM is the staple of the DeFi space. It is a fully automated program that allows users to create and manage liquidity independent of human bias and control.

Few Words about Liquidity Pools

A liquidity pool is storage for market players to allocate their funds and add a great deal of liquidity for everyone who wants to exchange the asset. In the traditional financial system, large banks act as such pools. They manage the funds of many investors and become the middleman to provide liquidity.

The liquidity pool in the crypto space is a stock of tokens locked in the self-executing smart contract. It is intensively used for decentralized exchanges at present.

What Are These Pools For?

If you are familiar with centralized exchanges, you already know that crypto lovers trade using the order book. Buyers want to purchase the asset at the lowest price, and sellers want to sell at the highest price. To make a deal, they must agree on some “fair price”. Either the buyer is ready for a higher price, or the seller accepts a lower price.

But what happens if none of the market players is ready to go for a fair price at all? Or if the quantity of tokens is simply not enough to satisfy the order? This is where automated market makers come right up into the play.

There are 3 approaches to dealing with the automated programs:

• Constant Function Market Maker (CFMM) is the most widespread approach. It is created specifically to provide a decentralized exchange of virtual currencies. It uses permanent functionality that works due to the full interaction of all self-executing contracts responsible for different digital assets.
• Constant Sum Market Maker (CSMM) is designed with automatic regulation of price ranges. If the amount of assets increases, the loss of value happens both rapidly and automatically.
• Constant Mean Market Maker (CMMM) is a more complex approach for a market maker that works with over 2 trading assets.

The benefits of AMMs are:

• there are new trading models
• the sliding price is minimum
• the faster and cheaper analog of the order book
• trading orders are delayed by milliseconds
• better liquidity
• the lack of bad actors manipulating the price
• reducing exposure to price fluctuations

What is Impermanent Loss (IL)?

It can be a little complicated to pinpoint an exact definition. That’s why people commonly misunderstand this buzzword. Now and then, it is associated with commissions, spreads, slippages, and even the time of block formation. But none of this affects the concept in any way. The formula does not depend on the things mentioned above.

Simply put, impermanent loss is the difference in price of the tokens between holding tokens in an AMM and holding them in your wallet.

It occurs when the price of tokens inside an AMM diverges in any direction. The more divergence occurs, the greater the impermanent loss is.

Why “impermanent”?

Because as long as the relative prices of tokens in the AMM return to their original state when you enter the AMM, the loss disappears, and you earn 100% of the trading fees.

However, this is rarely the case. In most cases, impermanent loss becomes permanent, eating your trade income, or even leaving you with negative returns.

The grand takeaway here? Providing liquidity can be a lucrative business. At the same time, you need to keep in mind the concept of IL.

Concluding Thoughts

We wish to stress that AMMs are in the preliminary stages of development and face a range of challenges, but projects are hard at work trying to solve for this.

At Gene Finance we are working on improving the current automated market maker ecosystem. Also, with a team of experts in DeFi, we aim to introduce the best trading experience for the widespread community. Recently, the Swap function was launched on Gene Finance. It is a AMM, soon to include a cross-chain relay, that enables traders from within and outside the Ethereum ecosystem to enter the Gene ecosystem and benefit from its revolutionary token economics.

Do you need more details? Join us on our website gene.finance, twitter, and discord for more information!

To learn more about Gene Finance, and stay updated on the latest developments:

• Visit gene.finance
• Follow us on Twitter @genefinance
• Join our Discord Group: http://discord.gg/xCs7Ehy