What are Automated Market Maker (AMM) and how do DEXs Work?

Main Takeaways

• Automated Market Makers (AMMs) are protocols that power most DEXs and use algorithms to provide liquidity for trading pairs.
  
  
• Users deposit tokens into liquidity pools to create a reserve of assets, and the price of an asset is determined by the ratio of tokens in the pool.
  
  
• Liquidity providers earn a share of trading fees as an incentive for providing liquidity, but they face impermanent loss if the value of assets fluctuates significantly.
  
  
• AMM DEXs offer continuous liquidity, transparency, and decentralization, eliminating the need for intermediaries and reducing the risk of censorship or manipulation.
  
  
• Well-known AMM DEXs include Bancor, Uniswap, SushiSwap, PancakeSwap, Curve, and Balancer.

What are Automated Market Makers (AMMs)?

AMMs are a type of protocol that powers most DEXs. AMMs use algorithms to provide liquidity for trading pairs. Unlike traditional exchanges or old-school DEXs like EtherDelta that rely on order books, AMMs employ smart contracts to determine prices and facilitate trades.   

How do AMMs DEXs Work?

Users deposit tokens into liquidity pools, creating a reserve of assets. The price of an asset is determined by the ratio of tokens in the pool. For example, in a constant product market maker (CPMM), the product of the reserves must remain constant. When a user wants to trade, they interact with the smart contract. The AMM calculates the price based on the current reserves and adjusts the pool accordingly.

Liquidity Pools and Liquidity Providers at AMM DEXs

At the core of every AMM DEX are liquidity pools, where users provide liquidity by depositing two assets into a “pool”. In return, they earn a share of trading fees as an incentive. The fees earned depend on the assets in the pool and the DEX chosen. Trading volume is also of key importance as it can affect the profitability of providing liquidity.

However, liquidity provision can be risky due to impermanent loss, which occurs when the value of one asset rises sharply, leading to a potential reduction in overall returns.

What is Impermanent Loss?

Impermanent loss occurs when the price of assets in a liquidity pool fluctuates significantly, reducing the value of a liquidity provider’s holdings compared to simply holding the assets. Liquidity providers deposit two assets into a pool, which maintains a balance. If the price of one asset changes, arbitrage traders adjust the pool’s balance, leading to a loss. 

Despite earning trading fees, LPs may face impermanent loss if price changes outweigh the fees earned, impacting their overall returns.

Advantages of AMM DEXs

AMMs DEXs offer several advantages over traditional order-book exchanges. They provide continuous liquidity, enabling users to trade at any time without relying on a matching engine. AMMs are also highly transparent, with all trades and prices visible on the blockchain. Additionally, AMMs are decentralized, eliminating the need for intermediaries and reducing the risk of censorship or manipulation.

Best Known AMM DEXs

The best-known AMM DEXs include Bancor, the inventor of the AMM model, and Uniswap, the most popular decentralized exchange. SushiSwap is recognized for its community-driven features, while PancakeSwap leads on the BNB Chain. Curve specializes in stablecoin swaps, and Balancer offers customizable liquidity pools.

Final Thoughts

The future of AMM DEXs looks promising as traders increasingly favor their decentralized, permissionless nature, especially in light of stricter KYC and AML policies on centralized exchanges. As DEXs evolve to handle cross-chain swaps and introduce advanced trading features beyond spot trading, they could become strong competitors to centralized exchanges. 

Their potential for innovation, combined with enhanced user autonomy, positions AMM DEXs for significant growth and adoption in the broader crypto ecosystem.