(Also known as AMMs)
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- Automated market makers incentivize users to become liquidity providers in exchange for a share of transaction fees and free tokens.
- An automated market maker (AMM) is the underlying protocol that powers all decentralized exchanges (DEXs)
- DEXs help users exchange cryptocurrencies by connecting users directly, without an intermediary.
- Simply put, automated market makers are autonomous trading mechanisms that eliminate the need for centralized exchanges and related market-making techniques. In this guide, we will explore how AMMs work.
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- Unlike centralized exchanges, DEXs look to eradicate all intermediate processes involved in crypto trading.
- They do not support order matching systems or custodial infrastructures (where the exchange holds all the wallet private keys.)
- As such, DEXs promote autonomy such that users can initiate trades directly from non-custodial wallets (wallets where the individual controls the private key.)
- Also, DEXs replace order matching systems and order books with autonomous protocols called AMMs.
- These protocols use smart contracts – self-executing computer programs – to define the price of digital assets and provide liquidity.
- Here, the protocol pools liquidity into smart contracts.
- In essence, users are not technically trading against counterparties – instead, they are trading against the liquidity locked inside smart contracts.
- These smart contracts are often called liquidity pools.
- Notably, only high-net-worth individuals or companies can assume the role of a liquidity provider in traditional exchanges.
- As for AMMs, any entity can become liquidity providers as long as it meets the requirements hardcoded into the smart contract. Examples of AMMs include Uniswap, Balancer and Curve.
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There are two important things to know first about AMMs:
- Trading pairs you would normally find on a centralized exchange exist as individual “liquidity pools” in AMMs. For example, if you wanted to trade ether for tether, you would need to find an ETH/USDT liquidity pool.
- Instead of using dedicated market makers, anyone can provide liquidity to these pools by depositing both assets represented in the pool. For example, if you wanted to become a liquidity provider for an ETH/USDT pool, you’d need to deposit a certain predetermined ratio of ETH and USDT
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- As discussed earlier, AMMs require liquidity to function properly.
- Pools that are not adequately funded are susceptible to slippages.
- To mitigate slippages, AMMs encourage users to deposit digital assets in liquidity pools so that other users can trade against these funds.
- As an incentive, the protocol rewards liquidity providers (LPs) with a fraction of the fees paid on transactions executed on the pool.
- In other words, if your deposit represents 1% of the liquidity locked in a pool, you will receive an LP token which represents 1% of the accrued transaction fees of that pool.
- When a liquidity provider wishes to exit from a pool, they redeem their LP token and receive their share of transaction fees.
- In addition to this, AMMs issue governance tokens to LPs as well as traders. As its name implies, a governance token allows the holder to have voting rights on issues relating to the governance and development of the AMM protocol.
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- Apart from the incentives highlighted above, LPs can also capitalize on yield farming opportunities that promise to increase their earnings.
- To enjoy this benefit, all you need to do is deposit the appropriate ratio of digital assets in a liquidity pool on an AMM protocol.
- Once the deposit has been confirmed, the AMM protocol will send you LP tokens.
- In some instances, you can then deposit – or “stake” – this token into a separate lending protocol and earn extra interest.
- By doing this, you will have managed to maximize your earnings by capitalizing on the composability, or interoperability, of decentralized finance (DeFi) protocols.
- Note, however, that you will need to redeem the liquidity provider token to withdraw your funds from the initial liquidity pool.