As one delves into the world of digital assets, it is easy to see that this is a place of remarkable innovation. The range of innovation includes complete paradigm shifts – such as distributed ledger technology – to slight improvements in market function – such as automated market making.
What is an AMM?
A market maker (or liquidity provider) in the traditional sense is an individual that provides both a buy and sell price in a tradeable asset to encourage trading, provide liquidity and generally support the efficient functioning of markets. In return for this service, the market maker typically earns a profit – the difference between the quoted bid-ask price. A simple, but critical role in efficient markets and one that has historically been handled by brokerage houses.
As you can probably guess, market participants in the digital asset space have found ways to decentralize and arguably improve on the market making function. AMMs allow assets to trade by replacing the “market maker” with a “liquidity pool."
Rather than matching buy-sell sides, users trade against a pool of tokens – the liquidity pool. The liquidity pool is a crowdsourced pool of digital assets that are locked up via smart contract. Essentially this pool of capital replaces the capital a brokerage house would use to buy/sell or hold inventory of an asset. Liquidity providers – those that provide capital to the liquidity pool – are typically rewarded for locking capital into the pool in the form of a proportionate share of the fees generated.
Why do AMMs matter?
In any early stage investment, liquidity is a major concern. Smaller market cap equities often trade very infrequently because there are no market participants willing to make markets. This illiquidity scares participants and often makes an asset un-investable.
By decentralizing the function into an AMM – any participant can offer liquidity in whatever size they feel comfortable via the liquidity pool. Early adopters of a digital asset can fund the liquidity pool themselves and potentially accelerate adoption.
Ultimately this removes a major barrier for investors.
Not all AMMs are created equally
The initial push for AMMs is often credited to Vitalik Buterin and his now famous reddit post from 4 years ago. Vitalik’s xy=k formula is the basis for some of the largest AMM protocols. Innovators have taken the XYK model and modified it to fix some of the major drawbacks. There are now a number of prominent AMM protocols with varying methodologies – Uniswap, Balancer, Curve, DODO, Bancor, Sushiswap, etc.
DEXs relying on AMMs have seen significant growth in adoption. Uniswap – arguably the most established of the DEXs nearly matches Coinbase in terms of volume.
While AMMs are a new and exciting way for participants to enter the DeFi ecosystem, if you're thinking of jumping into a liquidity pool, make sure you do your homework and understand risks such as impermanent loss. Despite these types of drawbacks, the fact that AMMs are decentralized and offer the average market participant an opportunity to directly participate and profit likely means they will continue to grow.