A Theory of Automated Market Makers in DeFi

The world of decentralized finance is mostly popular for its decentralized exchanges (DEXs) such as Uniswap, Saddle Finance, Sushiswap, and many other DEXs that offer traders non-custodial swapping of tokens at relatively low fees.

Unbeknownst to most DEX users, however, these DEXs’ ability to swap tokens without a centralized intermediary who supplies liquidity is enabled by the technology of the Automate Market Maker (AMM).

AMM-based protocols make up such a huge chunk of decentralized finance to an extent where Uniswap and Curve Finance ( two of the biggest DEXs on Ethereum) bring in billions in daily trading volumes and boast a combined Total Value Locked of over $25 billion.

On the surface, it is easy to assume that this massive rate of adoption is an indicator that AMMs are consolidated, well-understood technology. However, the sophisticated and complex designs implemented on AMM-based protocols leave many unaware of the risks and rewards that come with AMM protocols.

This article is a brief attempt to simplify the theory behind AMMs in DeFi to offer a better understanding.

What is an AMM?

An automated market maker is an algorithm programmed into a smart contract to allow digital assets to be traded without permission from a centralized entity through the use of liquidity pools instead of the traditional buyer and seller markets.

For a market to exist, a buyer and seller must exist. The seller must be willing to sell the asset at a particular price, and the buyer must be able to make a purchase based on the seller’s asking price. As a normal event in the market, it is expected that the buyer and the seller will offer conflicting prices as the buyer is looking to buy at the lowest price possible, and the seller is looking to sell at the highest price possible. When the buyer and seller settle on a price, the trade is executed, and that price becomes the asset’s market price. Almost every asset ranging from real estate to gold, stocks, and even cryptocurrencies relies on this dynamic interaction between buyers and sellers.

For this reason, a crypto exchange platform is only functioning as a middleman to connect the buyer and the seller to facilitate the trade. In most cases, the buyer and sellers are looking to make trades on token amounts that cannot be fulfilled by individual traders. This is where the centralized entity comes in to fill the gap thereby becoming a market maker. By ensuring that both buyers and sellers always have an opportunity to execute a trade, the centralized exchange platform has become the market maker. This, however, leaves room for the CEX to manipulate asset prices in the market.

How does an AMM Work?

AMMs however are financial tools designed in the form of executable mathematical equations that embody the role of a centralized market maker on a CEX. Through a smart contract linked to a liquidity pool with both assets on either side of the exchange, the AMM protocol can set a price for the exchange of each token whether there is a buyer or a seller.

The AMM protocol, therefore, removes intermediaries from the entire token exchange process through the use of an automated self-executing smart contract programmed with an AMM.

Conclusion: Challenges of AMMs

As innovative as AMMs can be, there are different types of AMM algorithms, each with its own set of challenges. For instance, AMMs based on the Constant Product Formular have been in the limelight for the impermanent loss they cause whenever one of the tokens in the pool assumes a volatile price swing.

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