The crypto world is so vast that it is now possible to gain crypto assets not only by trading but also by utilizing the Decentralized Finance (DeFi) ecosystem. You probably already understand that all DeFi applications run on a smart contract system along with one other mechanism which is Automated Market Makers (AMM). So, what do Automated Market Makers mean?
What Are Automated Market Makers?
In short, Automated Market Makers are a market mechanism in the DeFi world where the price is not determined by supply and demand. Advances in technology have allowed these traditional mechanisms to be replaced by constant mathematical formulations. As we know, DeFi projects come in many varieties. Starting from yield farming, crypto lending, and so on. In addition, there are also DeFi platforms that function as decentralized crypto exchanges (DEXs), such as Uniswap. Well, this Automated Market Makers mechanism is commonly applied on platforms whose names are mentioned recently.
Why is that? The DEX platform certainly facilitates many transactions per day with heavy liquidity. Moreover, the number of users continues to increase all the time. So, if the transaction process uses an order book like crypto exchange platforms in general, then the process of determining to buy and sell prices on the DEX platform will certainly take time.
Before AMM was invented, all prices were determined by ordering books. Where, brokers, market makers, and traders write the asking price (ask) and bid price (bid) manually. Fortunately, however, this process is prone to vulnerabilities and difficulty in trading liquidity. That’s why they introduced AMM. The idea is simple, which is to replace the price formation process from the manual bidding process with price formation using an algorithm. This will minimize the potential for fraud as well as increase liquidity in the market From 1990 to early 2000 Automated Market Makers continued to be developed. Today, some centralized markets such as the Nasdaq are already using AMM to some extent.
How Does This Automated Market Maker (AMM) Work?
The AMM system works like an order book in general. However, the trader does not need to interact with other traders to determine the bid and ask prices. Instead, they will interact with smart contract technology, where this technology will create a “personal marketplace” for themselves. This system is what makes AMM known as a peer-to-contract (P2C) system.
In addition, the AMM system also does not recognize the order book, so it does not contain any types of orders. The reason, of course, is that prices are formed from certain mathematical formulas. The AMM system is the opposite of a peer-to-peer transaction crypto asset exchange system. Alias, transactions that can be made directly between a trader’s digital wallet (wallet). For example this. If you sell Binance Coin (BNB) and trade it for BUSD on Binance DEX, then there will be other traders across there doing the opposite. Namely, selling his BUSD to get BNB.
Conventional people may not be able to imagine it in the past. How can you trade with someone you don’t trust without permission. If conventional markets require a bargaining process, the engines and algorithms make everything possible. Then where does the liquidity in the smart contract come from? Well, it comes from a collection of crypto token owners called Liquidity Providers (LPs). These LPs will then place their funds in a platform called “liquidity Pools”.
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What Is A Liquidity Pool?
A liquidity pool is a collection of crypto assets locked in smart contract technology. So far, liquidity pools have been used to facilitate lending and exchange rates, but their benefits are not limited to these two functions. In the future, the liquidity of crypto assets is very likely to become a complex money market and shift the existence of the current financial world.
These Liquidity Pools will provide the “coin supply” for the Automated Market Makers liquidity system. So, traders can exchange their crypto assets at any time without fear of the stock of their coveted crypto asset running low on the market. Anyone with an internet connection and ownership of ERC-20 tokens can become a Liquidity Provider. They will benefit in the form of fees paid by traders, as well as yields if they do yield farming.
When the liquidity pools are filled with assets, of course, the buying and selling process becomes easier to execute. However, when the market is quiet, it does not mean that traders’ trades are not selling well. Automated Market Makers make liquidity no longer an issue in liquidity pools.
In a simple form, a single Liquidity Pool accomodate 2 tokens and each pool forms a new trade market for the same token pair, for example, DAI/ETH which is a fairly popular Liquidity Pool on Uniswap. Based on the liquidity supplied to the pool, liquidity providers will receive a special token called Liquidity Provider (LP), which is proportional to the amount of liquidity they supply to the Pool. Approximately 0.3% fee is allocated to all LP token holders proportionally at the time the sale is activated by the Pool.
They will then burn the LP tokens if the liquidity provider wants to recover its underlying liquidity, plus any unpaid fees. According to the deterministic pricing algorithm, every Exchange Token driven by the Liquidity pool will result in a price change. This process is known as Automatic Market Maker (AMM).
The constant commodity market creation algorithm is used by the basic Liquidity Pool as is used by uniswap, where the amount of 2 tokens awarded remains the same. In addition, the Pool will still have liquidity regardless of the size of the trade that takes place due to the algorithm. The main reason is that as the number of targets increases, the algorithm will increase the token price asymptotically.
AMM (Automated Market Maker) or Automated Market Maker is a decentralized pool for asset trading that allows participants in the market to sell and buy cryptocurrencies. AMM is a financial tool unique to Ethereum and decentralized finance (DeFi). The technology owned by AMM is decentralized, can be accessed at any time, and does not depend on traditional interactions between buyers and sellers.