(Also known as AMMs)
What are AMMs?
- 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.
How do they AMMs in DEXs differ from Centralized Exchanges?
- 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.
How do AMMs work?
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
Liquidity Providers in AMMs
- 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.
Yield Farming on AMMs
- 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.