Automated Market Maker (AMM)
Automated Market Maker (AMM): AMM is said to have solved the biggest obstacle to the widespread adoption of DEXs, “Liquidity”. Unlike a centralized exchange, there is no controller who can exclude projects or users. AMM does not require users to set up specific accounts or KYC. The wallet address is all that is needed to interact with the protocols. DEXs are also a great way to release tokens to the market and bootstrap liquidity. No listing fees, anyone can set up a liquidity pool for any token.
AMMs have become a primary way to trade assets in the DeFi ecosystem, and it all began with a blog post about “on-chain market makers” by Ethereum founder Vitalik Buterin. The secret ingredient of AMMs is a simple mathematical formula that can take many forms. The most common one was proposed by Vitalik as:
tokenA_balance(p) * tokenB_balance(p) = k
and popularized by Uniswap as:
The constant, represented by
kmeans there is a constant balance of assets that determines the price of tokens in a liquidity pool.
For example, if an AMM has FootballChain (FBC) and bitcoin (BTC), two volatile assets, every time FBC is bought, the price of FBC goes up as there is less FBC in the pool than before the purchase. Conversely, the price of BTC goes down as there is more BTC in the pool. The pool stays in constant balance, where the total value of FBC in the pool will always equal the total value of BTC in the pool. Only when new liquidity providers join in will the pool expand in size. Visually, the prices of tokens in an AMM pool follow a curve determined by the formula.
In this constant state of balance, buying one FBC brings the price of ETH up slightly along the curve, and selling one FBC brings the price of FBC down slightly along the curve. The opposite happens to the price of BTC in an FBC-BTC pool. It doesn’t matter how volatile the price gets, there will eventually be a return to a state of balance that reflects a relatively accurate market price. If the AMM price ventures too far from market prices on other exchanges, the model incentivizes traders to take advantage of the price differences between the AMM and outside crypto exchanges until it is balanced once again.