Automated Market Makers (AMM) no longer rely on traditional buyers or sellers in the financial market, but instead, keep the ecosystem liquid through liquidity pools.
Automated Market Makers (AMM) constitute part of the decentralized finance (DeFi) ecosystem. They allow the non-custodial and automated trading of digital assets through liquidity pools instead of the traditional buyer and seller market. AMM users provide encrypted tokens for the liquidity pool, the price of which is determined by a constant mathematical formula. The liquidity pool, which can be optimized for different purposes, serves as an important tool in the DeFi ecosystem.
What is the automated market maker (AMM)?
First, let’s briefly talk about market makers (MM). Market makers play a vital role in the smooth operation of the financial market. They add liquidity to other market participants through constant quotations, thus trading the underlying assets at the best price and minimum slippage. In addition, by providing liquidity across various exchanges and eliminating the price difference between markets, they can improve the overall market efficiency and contribute to price discovery.
The automated market maker (AMM) uses algorithmic robots to simulate these price behaviors in electronic markets such as DeFi. Simply put, it is to calculate the buying and selling price according to the formula, so as to provide continuous quotations for the market.
But strictly, AMM is not a perfect solution. It does have some limitations, such as low capital utilization, additional risk exposure, and the widely-discussed impermanent loss.
Impermanent loss
Impermanent loss, in simple terms, refers to temporary book losses arising from the decrease in the net asset value when asset prices fluctuate drastically. However, if assets are put into the liquidity pool to provide liquidity, the price is separated from the external market due to the AMM mechanism and will not be automatically adjusted. Instead, it will stay in balance with the external market price when arbitrageurs buy and sell assets. The more the price falls, the more assets will be bought, and vice versa. Such arbitrage usually turns the impermanent loss into the permanent one.
LPs in the AMM pool will suffer some inherent risks and inefficiencies. The most important and relatively esoteric risk is the impermanent loss (IL), which is the difference in the value of the asset portfolio over time between when you are holding tokens in an AMM liquidity pool and just simply holding them on the blockchain.
Example of Impermanent Loss
Initial state: Assume that there are 900 CET and 900 USDT in the CET/USDT liquidity pool, 1 CET=1 USDT at this moment.
Step 1
Assuming that the liquidity provider Mr. Ming provides 100 CET and 100 USDT for the CET/USDT liquidity pool, there are 1,000 CET and 1,000 USDT in the pool. With 1 CET=1 USDT, Mr. Ming has 10% of the "shares" in the CET/USDT liquidity pool and his asset value is 200 USDT, and the liquidity pool is balanced at this moment;
Step 2
Assuming that the trader Mr. Li sells 100 CET in the CET/USDT liquidity pool for (1,000-1 million/1,100)=90.909 USDT and there are 1,100 CET and 909.091 USDT remaining in the liquidity pool, then 1 CET=0.826 USDT, and the liquidity pool is out of balance.
Step 3
Assuming that the liquidity provider Mr. Ming withdraws liquidity with the liquidity pool at 1,100 CET and 909.091 USDT, so he actually withdraws: 1,100 CET * 10% + 909.091 USDT * 10%, i.e. 110 CET and 90.9 USDT. So his asset value is 0.826 *110 + 90.9=181.76 USDT;
Step 4
Calculated on the value when Mr. Ming added liquidity, the 100 CET and 100 USDT Ming deposited were actually valued at 200 USDT. The impermanent loss of 18.24 USDT is incurred.
Note: To facilitate the above calculation, the transaction fees are ignored.
This happens because the AMM market price does not automatically adjust. Therefore, when the price of the entire market changes, arbitrageurs will step in and gain profits at the expense of liquidity providers. As a result, the actual income of the LP in the AMM pool is the balance between the cumulative transaction fees and the impermanent loss caused by the price difference.
Limitations of AMM
In addition to impermanent losses, AMM still suffer problems such as low capital efficiency, insufficient liquidity utilization and multi-token risk exposure. Since AMM distributes funds evenly over the entire price range (0, +∞), only funds allocated near the market price can be effectively used, while a large part of the funds are only available when the pricing curve begins to change exponentially. As a result, AMM needs a lot of liquidity to match the slippage in traditional order-book transactions.
Undoubtedly, the inherent limitations of AMM also drive its continuous iteration and innovation.
AMM has been significantly improved. The past AMM 1.0 boom was represented by Uniswap, Curve, and Balancer, all of which were commendable in terms of financial risk maturity, capital size, and user base.
AMM 2.0 is deemed the "fund-based AMM", represented by projects such as Bancor V2 (the inheritance of Balancer) and MOV Superconducting V2.
AMM 3.0 may come in a newer form. For example, it may be used in more scenarios. As we can see recently, some try to apply AMM in perpetual contracts, some use AMM in the IPO, and even some in traditional finance are studying AMM. All this may form a cycle.
It is worth mentioning that CoinEx launched the AMM in February 2021 to improve the liquidity of the exchange market. It combines AMM with the order book as the trading mechanism, and the system automatically converts the liquidity pool into an order book.
AMM vs. Order Book
Like Bancor, Uniswap and OneSwap, CoinEx uses the constant product market maker (CPMM) algorithm in AMM, which can provide liquidity for the market regardless of the size of the order book and the liquidity pool.
From Uniswap to OneSwap, AMM technology is providing new possibilities for ensuring instant liquidity for any digital asset.
Compared with other decentralized transaction protocols, OneSwap introduces an on-chain order book model based on AMM. Users can initiate market-order transactions or limit-order transactions, and set themselves to sell or buy orders at the target price, which are automatically executed. The combination of AMM and the order book not only provides users with a familiar way of trading limit orders, but also further enhances the liquidity of digital currency assets.
AMM allows everyone to make the market and also benefits from providing liquidity. Both the buyer and the seller are interacting with the liquidity pool on the chain, and the liquidity provider gets transaction fees as the income.
In summary, AMM uniquely provides the opportunity for the general users to get (by bearing risks) transaction fees as income. It is also an innovative market-making mechanism, which fundamentally changes the way cryptocurrencies are traded.
References:
All-around Interpretation of the Current Development Conditions of Decentralized Exchanges: AMM, Order Book and the Aggregator
AMM's Scalability Trade-offs: Exploring New Opportunities for UniSwap
The Development of AMM: From 1.0 to 3.0
"AMM+Order Book" Model, An Effective Way to Promote the Liquidity of Digital Assets
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