An automated market maker (AMM) is a type of decentralized exchange that uses algorithms to price assets in liquidity pools. It can provide a more efficient and less costly service than centralized exchanges, which use a third party to handle transactions between traders.
AMMs are a great way to diversify your crypto portfolio and trade in a simple and transparent manner, without the need for a central bank or trusted third party. However, they do come with some risk, as you could lose your investment if the algorithm makes pricing changes too widely.
Traders using AMM-based DEXs to trade cryptocurrencies include professional investors, institutions/hedge funds, and decentralized finance (DeFi) projects. They can leverage AMMs’ tools and features for asset management, arbitrage opportunities, and capital raising.
DEXs based on AMM crypto models have several advantages that CEXs cannot match, including decentralization and non-custodial ownership of digital assets. Unlike traditional exchanges, AMM-based DEXs do not require users to trust a third party with their digital assets and are able to process billions of dollars worth of tokens per day.
AMM-based exchanges use smart contracts to execute trades and ensure a secure environment for users. They are decentralized and permissionless, relying on their own algorithms to determine prices, and crowdsource liquidity from a pool of digital assets.
They are also scalable, making it possible for DEXs to handle a high volume of tokens and transaction volumes. These advantages make DEXs a popular choice for trading and investing in crypto.
Liquidity Pools and Impermanent Losses
As discussed above, AMMs rely on liquidity pools to support their pricing algorithms and to keep them functioning efficiently. These pools are made up of a crowdsourced collection of assets that are bought and sold by users who deposit their own cryptos to the pool. These users are referred to as liquidity providers (LPs).
When a user deposits coins in the pool, they receive an LP token. These tokens represent a percentage of the transaction fees that the pool accrues on transactions. This rewards liquidity providers for contributing to the pool, and it enables them to receive a passive income from the pool.
Alternatively, some AMM-based DEXs allow liquidity providers to participate in yield farming. This means a user can deposit a certain ratio of assets in the pool and earn additional reward tokens by participating in activities like buying or selling other digital assets within the pool.
This allows users to earn an extra profit through these activities, while keeping the assets they own. This is an excellent incentive for users to contribute to a pool, as it provides an easy way to earn a passive income from their own holdings while still earning transaction fees on trades.
AMMs can also be a good way to avoid slippage issues in the market. This is because the algorithm for determining the price of a token will always reflect the current value of the token, and not how much one particular trader is willing to pay for it.
