It is no secret that cryptocurrency represents a new asset class that is slowly gaining popularity among investors and analysts. The cryptocurrency industry is still in its nascent stages, and one of the biggest challenges for this market is liquidity.
AMMs (automatic market makers) are one way to improve liquidity in crypto. In this article, we’ll explore what AMMs are and what they do for the market. We’ll also discuss some of the challenges AMMs are facing. And finally.
When Uniswap was introduced in 2018, it became the first decentralized platform to implement an automated market maker (AMM) mechanism. Every decentralized exchange (DEX) relies on AMMs. DEXs allow customers to trade cryptocurrencies directly with each other by removing the middleman. So, essentially, automated market makers are algorithms that are used to execute trading operations on decentralized exchanges without third-party intermediaries and market makers.
The Concept of Market Making
To begin with, let’s look at what a market maker is. Market makers are entities that buy and sell assets to provide liquidity to a market. In order to achieve this, they set the bid and ask prices for the asset and keep a certain amount of it on both sides of the order book. By doing so, they can fill orders from other traders who want to buy or sell the same asset.
Market makers are usually large banks or brokerages in traditional financial markets. They provide a steady stream of buy and sell orders for the purpose of keeping markets liquid. As a result, they usually charge a small fee. Nevertheless, crypto market making is a bit different.
AMMs are computer programs that use algorithms in order to determine the bid and ask prices for crypto assets according to the supply and demand of the market. These smart contracts are basically an alternative to market makers in centralized markets. Instead of setting up bids and asks, they calculate prices automatically, thus providing crypto market liquidity. AMMs are one of the key components that power decentralized crypto exchanges (DEXs).
One advantage of this system is that it reduces the spread between bids and asks, which means trading becomes more affordable. The second advantage is that it eliminates the need for a centralized exchange. Because there is no central authority that could be taken down by hackers, the system is safe and secure.
How Do AMMs Work?
Following our explanation of what an AMM is, let’s examine its workings in more detail.
AMM prices assets based on supply and demand using specific algorithms. In the event an investor wishes to buy an asset, he sends an order to the AMM, and the AMM then calculates the best price for that asset. If an investor wants to purchase an asset, he submits an order to the AMM, and the AMM then uses its algorithms to determine the best price to buy it.
AMMs aim to find the best prices for their clients. That’s what makes them different from traditional exchanges, which tend to set fixed prices for various assets.
Why Are AMMs Beneficial?
Due to their ability to provide much-needed liquidity in crypto, AMMs are extremely popular in the cryptocurrency industry. Without AMMs, buying and selling assets in a decentralized manner would be impossible.
It is also possible to trade directly with other users with AMMs. If you trade on a traditional exchange, you must do it through the exchange itself. An exchange can charge you fees for their services. When trading with AMMs on DEXs, you are avoiding any third party and trading directly with other traders.
It’s also important to note that AMMs are less susceptible to manipulation than traditional exchanges since they use algorithms to price assets, making it difficult for people to manipulate them.
What Challenges Do AMMs Face?
Although AMMs offer many advantages, they also face some challenges. For example, AMMs are still relatively new, and their regulatory status lacks clarity. This can change in the future, which can become a risk for users and owners of decentralized platforms.
In addition, AMMs are often used for trading illiquid assets, which can lead to slippage, a phenomenon in which the price of an asset changes from the expected price. Having a slippage in a trade can lead to profit loss as well as difficulty in executing a trade.
In addition, AMMs can be affected by front-running, which is when traders place orders ahead of others to take advantage of price movement. Front-running reduces liquidity and can interfere with the functioning of AMMs.
Although there are challenges to AMMs, they are becoming increasingly important as the crypto ecosystem develops and regulations become more clear.
The Future of Automated Market Makers In Crypto
Considering all that we discussed above, how do AMMs stand to fare in the crypto world? Despite their disadvantages over traditional exchanges, AMMs appear to offer a bright future. Many leading decentralized projects have already embraced them. All in all, it appears that AMMs are here to stay and are going to have a significant impact on the crypto space in the future.