Automated Market Makers (AMM): Priming a Financial Revolution using Smart Contracts

It was in July 2018 when Vitalik Buterin, in a well-balanced TechCrunch Sessions: Blockchain, said he wished all centralized exchanges would burn in hell.

While the innovator said he understood that everyone's needs varied and it was incredibly hard for every aspect of people's lives to be wholly decentralized and centralized, it opened the floor that led to a protracted debate on decentralized exchanges, the center of what now is DeFi.

Vitalik noted that while crypto-to-crypto exchanges, then, were in the early stages of development, their appeal of allowing trustless exchange of tokens was their main value proposition. The success of centralized exchanges, like Coinbase, he notes, would only make crypto 'less fun.' 

The appeal of distributed exchanges lies in users' ability to transact without necessarily exchanging passwords or submitting personal details. All a user requires is a non-custodial wallet. After that, swapping is trustless, with confirmation done at the pace of the primary chain's block generation time.

What is a Decentralized Exchange?

Decentralized exchanges, or simply swapping protocols, are just that: They are decentralized portals where users can exchange one token for another without a go-between. These platforms are formed to purposefully meet the permissionless swapping needs of one blockchain. For instance, in Ethereum, a DEX would allow the exchange of utility ERC-20 tokens. Over time, some of these tokens, like Chainlink's LINK, for instance, command billions in market cap and several hundreds of millions in daily trading volumes. Accordingly, they are relatively liquid. Nonetheless, DeFi innovators discovered that token swapping is even easier if liquidity provision is shifted to extract from the billions held by token holders within the ecosystem.

In a decentralized swapping system, liquidity was--before the explosion of decentralized finance from late 2019--a challenge. However, creators took the lead from Compound, incentivizing liquidity provision, changing the game. By allowing users to create pools and provide liquidity for a share of transaction fees, they reckon, would rid liquidity problems. Their bet paid off. Now, all DEXes have a way of offering rewards for liquidity provision in exchange for a portion of transaction fees. This is without the liquidity provider signing up, revealing their personal information, or swapping parties having to register. Some of the leading swapping protocols in Ethereum, for instance, are now more liquid than some top centralized exchanges.

The Automated Market Maker (AMM) Model

At the center of this revival is the concept of the automated market maker (AMM). Simply put, an AMM is an audited smart contract deployed by a DEX. This AMM often allows users to create liquidity pools of the deployed blockchain's tokens. In Ethereum's case, an AMM's smart contract will enable one to create a liquidity pool of ERC-20 tokens. Within these liquidity pools, users can exchange one token for another cheaply and without an order book. 

The Evolution of AMMs

Typically, there are two types of AMMs. In one category, there are those which professional market makers set up. There might be a tinge of centralization in this arrangement; however, they rely on liquidity pools to operate. An example of this provider is the Kyber Network, where liquidity provision is sealed. Instead, only professional market makers or the team can supply liquidity. The other category is fully automated and powered by algorithms without any form of intermediation. The creation of liquidity pools is free, and liquidity providers can supply their assets, earning passive income as a result. 

Protocols in the latter category are usually considered as 'true' AMMs because of the absence of limitations in those who can supply liquidity and the type of users. Users within their respective ecosystem, be it in Ethereum, Waves, or the Binance Smart Chain (BSC), can supply liquidity if they wish to. 

There is Uniswap in Ethereum. This protocol is the first successful DEX and is the largest globally, autonomously managing over $5 billion of various digital assets. Typically, DEXes are open-source, maintained by a stream of swapping fees. Because Uniswap's code is publicly accessible, there have been several variants of DEXes in Ethereum and competing platforms forking from its code. In the BSC, PancakeSwap split from Uniswap and is now dominant, allowing traders to swap BEP-20 tokens.

One more example is BloctoSwap on the Flow Blockchain. Here, like other AMM DEXes, suppliers contribute liquidity in equal proportions. At present, the DEX only supports the FLOW/tUSDT pair but has accumulated over $10 million in trading volumes - and likely to increase since it is the first and the only in the Flow ecosystem. 

The Quest for Yield Maximization and Capital Efficiency by AMM Models

From Ethereum, Binance Smart Chain (BSC), Waves, IOST, to the Flow Blockchain, DEXes relying on AMM models continue to grow. Year-to-date, for instance, in Ethereum, DeFi TVL has expanded over 80X as the number of projects listing their assets on various exchanges also rack up. At over $81 billion locked in different DeFi protocols and more than $5.9 billion in Uniswap alone, it is evident that there is interest, and investors are pouring in capital--supporting development.

Investor participation, as shown by the entry of high-profile crypto funds offering direct support to some of the leading DEXes, means they believe in the DeFi future. From a more technical perspective, it could also mean DEXes using AMMs offer a superior and more efficient solution with a chance to carve out a decent market share from CEXes. Aforementioned, the state of trustless exchange has been marked with constant, inevitable evolution. 

The rollout of the more efficient AMM-reliant DEXes has demonstrated that it can launch a swapping protocol without counterparties. This is because traders can trustlessly swap tokens directly in a liquidity pool where tokens fulfilling the demand of both sides of the equation are stored, enabling trustless exchange. Instead of a middle man, swapping tokens follows a mathematical model algorithmically guiding the trading balance, ensuring liquidity is at any time sufficient. It is a deviation from previous models using order books, limiting liquidity and negatively impacting user experience. 

With AMM, all supported liquidity pools are funded by the community of liquidity providers. They submit tokens of equal value to represent both sides of the trade. For their supply, liquidity providers receive a prorated benefit proportional to their contribution. This share of the liquidity pool, called liquidity provider token, is another innovation that's already stretching DeFi limits, making the sphere attractive with creations like high-yielding liquidity farms. 

DeFi is Exciting, but Loopholes must be sealed

However, as exciting as DeFi and AMM are as a finance innovation disrupting the status quo, there have been loopholes. For example, competing protocols can siphon liquidity in a "vampire attack." 

The Uniswap-SushiSwap debacle already showed how protocols could destabilize one system as the ensuing liquidity crunch threatens the stability of the whole ecosystem. The "problem" lies in the open-source nature of DEXes' code. Adhering to the principles of the blockchain, swapping platforms launching from decentralized blockchains are open-source, continuously improved by the global community with bounty programs to incentivize thorough audits. 

At the same time, these codes are also audited by third parties, primarily reputable blockchain security firms. Even so, to avert future exploits, Uniswap could be leading the way to licensing their innovation while cementing their lead. The recently launched Uniswap v3 with liquidity concentration incorporating elements of NFTs has a business license valid for three years. During this time, v3 code can’t be forked and improved by other projects drawn by Uniswap's creation. This limits the speed of enhancements and is against the tenets of blockchain—community and open-source.

AMM is also in the spotlight because of inefficient capital utilization—a problem actively being addressed—and risk exposure due to the impermanent loss problem. DeFi as a new subsector is a perpetual quest to gain maximum efficiency and yield maximization, ensuring that capital is not idle. Under the DeFi guiding ethos, capital should always be utilized either through lending or liquidity provision to benefit the provider while keeping the system running. Presently, there are holes to be sealed, requiring even more innovation to align with ideals despite the decentralization of the base layer. For this reason, the innovation mill in DeFi will continue to run, and new AMM models launched to address capital inefficiency and the problem arising from impermanent losses among other hitches.

Conclusion

DeFi is fast-evolving, and AMMs represent this fact, revealing the desire of developers to continuously build user-centric, privacy-preserving, and highly functional open-source products. They are the centerpiece of a financial revolution gradually allowing blockchain purists to move closer to their goal. AMMs are opening up more opportunities for businesses and, most importantly, giving users more options to swap trustlessly without privacy intrusion while also earning passive income when choosing to supply liquidity in various pools.

Disclaimer:

The author does not have any vested interest in the projects mentioned above.

The opinions in this article belong to the author alone. Nothing in this article constitutes investment advice. Please conduct your own thorough research before making any investment decisions.