What is an Automated Market Maker (AMM)? | Chain Knowledge Encyclopedia

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1. What is an Automated Market Maker?

An Automated Market Maker (AMM) is part of the decentralized finance (DeFi) ecosystem that allows users to trade digital assets in a permissionless and automated manner using liquidity pools instead of traditional buyer-seller markets. AMM users provide cryptocurrencies to liquidity pools, with prices determined by a constant mathematical formula.

Today, AMM-based liquidity pools have become essential tools in the DeFi ecosystem, especially with Uniswap rising to become the highest-volume decentralized exchange thanks to its AMM mechanism, and the UNI token entering the top ten in cryptocurrency market capitalization, while the influence of decentralized exchanges based on traditional order book models has relatively diminished.

On traditional trading platforms, buyers and sellers provide different prices for assets. When other users find the listed price acceptable, they execute the trade, and that price becomes the market price for that asset. Stocks, gold, real estate, and most other financial assets rely on this traditional market structure for trading. However, AMMs have a different method for trading assets.

AMMs are a financial tool unique to Ethereum and decentralized finance (DeFi). This new technology is decentralized, can be used for trading at any time, and does not rely on traditional interactions between buyers and sellers. This new method of exchanging assets embodies the ideals of Ethereum, cryptocurrencies, and blockchain technology: no single entity can control the system, and anyone can build new solutions and participate.

2. Liquidity Pools and Liquidity Providers

Liquidity refers to how easily one asset can be converted into another (usually fiat currency) without affecting its market price. Before the advent of AMMs, liquidity was a challenge for decentralized exchanges (DEX) on Ethereum. As a complex new technology, the number of users on the buyer-seller side was low, making it difficult to find enough willing participants for regular trading. AMMs addressed the issue of limited liquidity by creating liquidity pools and offering fee incentives to liquidity providers. The more assets in the pool, the higher the liquidity of the asset pool, making trading on decentralized exchanges easier.

On AMM platforms, users trade against token pools and liquidity pools rather than between buyers and sellers. The core of the liquidity pool is a shared token reservoir. Users provide tokens to the liquidity pool, and the price of the tokens in the pool is determined by a mathematical formula.

Any user with an internet connection and any type of ERC-20 token can become a liquidity provider by supplying tokens to the AMM's liquidity pool. Liquidity providers typically earn transaction fees, usually 0.3%, for providing tokens to the pool. This fee is paid by users interacting with the liquidity pool. Today, liquidity providers can also earn returns in the form of project tokens through so-called "liquidity mining."

3. Constant Product Formula

AMMs have become the primary way to trade assets in the DeFi ecosystem, all starting from a blog post by Ethereum founder Vitalik Buterin about "on-chain market makers." The implementation of AMMs is a simple mathematical formula that can take various forms. The most common proposal by Vitalik is:

tokenAbalance(p) * tokenBbalance(p) = k

and promoted by Uniswap as:

x * y = k

The constant represented by "k" means there is a fixed asset balance that determines the price of tokens in the liquidity pool. For example, if an AMM has both ETH and BTC as volatile assets, each time ETH is purchased, the price of ETH will rise because there is less ETH in the pool than before the purchase. Conversely, the price of BTC will fall due to the increased amount of BTC in the pool. The fund pool maintains a constant balance, and the total value of ETH in the pool will always equal the total value of BTC in the pool. The size of the fund pool only expands when new liquidity providers join. Visually, the price of tokens in the AMM pool follows a curve determined by the formula.

In this constant balance state, purchasing one ETH will cause the price of ETH to rise slightly along the curve, while selling one ETH will cause the price of ETH to fall slightly along the curve. The price of BTC in the ETH-BTC pool behaves exactly the opposite. Regardless of how much the price fluctuates, it will eventually return to a balanced state, reflecting a relatively accurate market price. If the AMM price deviates too far from the market price on other exchanges, the model incentivizes traders to arbitrage the price differences between the AMM and their external cryptocurrency exchanges until balance is restored.

The constant product formula is a unique component of AMMs that determines how different AMMs operate.

4. Iterations of Automated Market Makers

In Vitalik Buterin's original call for on-chain market makers, he emphasized that AMMs should not be the only option for decentralized trading. Instead, multiple methods of trading tokens are needed, as non-AMM exchanges are crucial for maintaining the accuracy of AMM prices. However, he did not foresee the subsequent development of various AMMs.

The DeFi ecosystem has rapidly evolved, leading to the emergence of three main AMM projects: Uniswap, Curve, and Balancer, with most new DeFi projects also adopting the AMM model.

Uniswap's leading technology allows users to create a liquidity pool with any pair of ERC-20 tokens at a 50%/50% ratio, becoming the most enduring AMM model on Ethereum.

Curve focuses on creating liquidity pools for similar assets among stablecoins, thus addressing the issue of limited liquidity while offering the industry's lowest rates and most efficient trading.

Balancer expands the limitations of Uniswap by allowing users to create dynamic liquidity pools with up to 8 different assets in any ratio, thereby enhancing the flexibility of AMMs.

The iterations of automated market makers have proven to be essential financial tools in the rapidly evolving DeFi ecosystem and are a sign of the industry's increasing maturity.

Further Reading:

“Can AMM Liquidity Mining Become a Sustainable Business Model?”

“A Comprehensive Interpretation of the DEX Industry Landscape and Development Trends”