Automated Market Makers (AMM): What They Are and How They Work
AMM is one of the cryptocurrency trading options that does not require an intermediary. The system combines smart contracts and incentives that ensure the validity of tokens. Thus, the traditional centralized cryptocurrency trading system, which works without the supervision of users, is changing.
Automated markets versus traditional markets
The primary purpose of any market is to meet the requests of traders. It is essential to create demand relevant to sellers and buyers of assets. It is worth following the cryptocurrency blog to keep abreast of news on the market.
With the traditional model, there is a single point of control. The user needs to undergo KYC verification to access assets. A centralized exchange sets the value of trading pairs based on the order book.
The book of orders, or the book of offers, is a protocol of requests from customers. That’s where they offer value. The exchange itself does not issue a deal. It provides an offer based on the demand of traders.
A sufficient number of orders for the sale and purchase of the assets is necessary to ensure a fair value. With low liquidity, significant gaps in value appear. It leads to inefficiency and market slack.
What is a market maker
The market maker is needed to ensure the validity of the assets. A centralized exchange automates all processes and provides control of operations. It is a kind of intermediary that guarantees the safety and continuity of all functions.
If this is not done, you can expect a drop in liquidity. That is, the value of assets will change during a transaction. It often happens in the crypto market if the exchange does not guarantee the automation of the process.
Exchanges rely on traders or financial companies to provide the necessary level of liquidity. They are the ones who create the demand required for buying and selling cryptocurrency. It ensures that all agents are open for the operation.
In the centralized exchange system, liquidity providers act as market makers. They facilitate the processes necessary to ensure cryptocurrency pairs’ liquidity.
How Automated Market Makers (AMM) work and why you need them
The main goal of automated exchanges is to eliminate all intermediaries in trading. The system does not store wallet data and does not support an order matching system. Thus, the deal supports trading that does not require wallets with private keys.
Automated systems use autonomous protocols to aggregate liquidity. The work of protocols is ensured by smart contracts that determine the price of assets and provide liquidity.
You need to know the following things about AMM
- Trading pairs exist in liquidity pools.
- Any user can ensure the pair’s liquidity. It is only necessary to invest the relevant assets in the pool.
Automated market makers use the x*y=k equation to ensure relative asset parity. It is necessary to establish a relationship between assets. In the equation, k is a constant, and x and y are assets. Simply put, the system ensures that the multiplication of the selected assets must always be equal to one number.
For large amounts, the principle of arbitrage trading is used. In this case, the asset’s value may be lower than the market value. Arbitrage trading encourages buying tokens at a low price to make room for other purchases.
The above formula is not the only one for automated market makers. Some systems use calculations to carry out eight-digit transactions in a single activity pool.
Should I be afraid of Impermanent loss
Impermanent losses are the risks associated with the use of automated exchanges. They appear when the value of assets is not stable. Impermanent loss occurs when the value of the combined assets deviates from the price deposited.
But this is not always the case. Price fluctuations can lead to both losses and profits. Very often, the potential price increase can completely cover the non-permanent losses. It is essential to monitor the value of assets and take the necessary measures in time.
Automated market makers are necessary to solve specific questions when using cryptocurrency exchanges. In particular, they help to improve the efficiency of capital investment and to allocate funds correctly.
The system helps avoid mistakes during the operation and refuses intermediaries’ services. AMM is necessary to allocate funds quickly and establish the value of assets.
