Decentralised financial markets are becoming popular because of their ability to eliminate an intermediary between transacting parties. One of the unsung heroes of this success is the automated maker protocol (AMM) within these transaction systems.
AMM is the underlying protocol used by decentralised exchanges with an autonomous trading mechanism. This eliminates the need for centralised authorities like exchanges and other financial entities. Put simply, it allows two users to transact their assets without any intermediary facilitating the exchange.
What is a market maker?
Market makers are essentially liquidity providers. In trading, liquidity refers to how quickly and seamlessly an asset can be bought or sold. Let us understand this with an example. Suppose trader A wants to buy one bitcoin. The centralised exchange that oversees the trade provides an automated system to find a seller, trader B, who is willing to sell a bitcoin at the rate quoted by trader A. Here, the exchange is acting as a middleman.
But what if no traders are selling a bitcoin that matches trader A’s buy order? In this scenario, the liquidity of the asset (in this example, bitcoin) is low. This means that there is less trading activity of the asset, and it is harder to buy or sell it.
This is where the centralised exchange needs market makers. Certain financial institutions or professional traders provide liquidity by creating multiple buy/sell orders to match the orders of retail investors. The entity that provides the liquidity becomes the market maker.
How are automated market makers different?
Automated market makers are a part of decentralised exchanges (DEXs) that were introduced to remove any intermediaries in the trading of crypto assets. You can think of AMM as a computer programme that automates the process of providing liquidity. These protocols are built using smart contracts — a computer code that executes itself — to mathematically define the price of the crypto tokens and provide liquidity.
In the AMM protocol, you do not need another trader to make a trade. Instead, you can trade with a smart contract. So trades are peer-to-contract and not peer-to-peer. If you want to trade a particular crypto asset with another, like Ether (ethereum’s native currency) for Tether (ethereum token pegged to the US dollar), you need to find an individual ETH/USDT liquidity pool. As mentioned above, what price you get for an asset you want to buy or sell is determined by a mathematical formula.
In AMM, anyone can be a liquidity provider if they meet the requirements stipulated in the smart contract. So, in this example, the liquidity provider will need to deposit a pre-determined amount of Ether and Tether tokens to the ETH/USDT liquidity pool. In return for providing liquidity to the protocol, the liquidity providers can earn fees from trades in their pool.
Why is AMM important to investors?
AMM helps set up a system of liquidity where anyone can contribute to it. This removes any intermediary lowering transaction fees for investors. High liquidity is essential for healthy trading activity. If there is less liquidity, it could cause slippage. Low liquidity introduces high volatility in the prices of assets in the market.
AMMs also allow anyone to become a liquidity provider, which comes with incentives. Liquidity providers get a fraction of the fees paid on transactions executed on the pool.