Crypto Trading Tips: What’s AMM And How To Use It?

Cryptocurrency exchanges with AMM are different from traditional ones, and today we will find out how. AMM stands for "Automatic Market Maker", which essentially reveals the meaning – on such exchanges, orders are placed automatically without waiting in the order book. Most modern decentralized crypto exchanges use this concept. In this article, we will figure out what AMM is and give examples of popular exchanges using this concept.

What is AMM?

Cryptocurrency is a convenient tool for trading and investing on the Internet, but the peculiarity of the first cryptocurrencies was that users could not get them before the launch of the blockchain and miners. Initially they had only 2 ways to get the assets:

1. Buy equipment and mine new coins using mining.
2. Buy already mined coins from miners on any of the trading platforms.

It doesn’t seem like a big deal now, but in the crypto market before the DeFi era, users could only buy cryptocurrencies on centralized exchanges (CEXs). These exchanges used order books to create the market by matching user and market maker orders. That doesn't seem like a problem either, because CEXs are convenient, affordable, and secure, right? However, centralized exchanges have risks that can affect not only the company itself, but also users. The Coinbase Q2 2022 10-Q reportsays that since users’ cryptocurrency is formally considered the exchange’s assets, in the event of bankruptcy, these funds can also be used as collateral for creditors.

So Crypto World tried to find a solution, which would allow owners to store and exchange cryptocurrency without being exposed to counterparty (exchange) risks. NXT and Counterparty developed the first peer-to-peer exchanges back in 2014. Early decentralized marketplaces used the same order books, but tried to integrate them with smart contracts to move away from a centralized operator.

In 2016, Vitalik Buterin first introduced the concept of an automatic market maker (AMM), which was described in detail in the work “On Path Independence” in 2017. According to Buterin's vision, AMM is a set of smart contracts that form the price of an asset based on the ratio of assets in the liquidity pool. The pools perform the function of market makers, but since the exchange rate in them is set algorithmically by a smart contract, the counterparty risk is much lower than when working with centralized platforms.

How does AMM work?

In fact, AMM were used on stock markets, including trading in gold, oil, shares – market makers helped the investor find liquidity in order to sell or buy an asset close to the public market value. The transaction is completed if the price expectations of the seller and the buyer correspond. In global financial markets, this is achieved by using the order book.

The user places an order at a necessary price. This application is placed in the order book for buying and selling. There it awaits a counter offer. Operation is complete only when someone wants to make a deal at the same price. It works the same way on the crypto market.

Basically, AMM is a smart contract that provides liquidity to the decentralized finance ecosystem in ways that differ from traditional order book matching. Crypto assets are traded using an automated algorithm based on funds held in liquidity pools. The exchange is thus instantaneous without waiting for a counteroffer.

AMM itself determines the market price of the token based on the ratio of the two assets in the pool. The only condition for successful trading is the presence of a sufficient amount of liquidity in the pool. To ensure this, DeFi protocols reward users for supplying liquidity.

Characteristics of AMM markets and liquidity pools

To interact with crypto AMM services, a user must know the basic elements and principles on which the work of such platform is based:

• Liquidity is the most important indicator of any market. Liquidity determines how easy it is to exchange one asset for another.

  
  

• A liquidity pool is a smart contract that holds a supply of two or more tokens. The pool does not require a counterparty for the exchange: the user simply transfers one token to the pool and immediately receives another one.

  
  

• Price slippage is the difference between the expected and final value of a trade. Slippage occurs in traditional and order book markets, but AMM has a greater potential for slippage. If you are trying to make a large trade in a small pool of liquidity, then the final price may differ from the expected one.
  

• Liquidity providers – decentralized platforms do not inject their own funds into liquidity pools, instead, users themselves place assets in the pool. For providing liquidity, they receive  commissions from transactions in the pool and additional rewards.
  

• Impermanent loss. You provided cryptocurrency to a liquidity pool. The price of tokens has changed from the original, so the number of contributed tokens will also change and you will face unrealized losses. If the price of both tokens from the pool grows, you will earn. The more the price differs from the original, the greater the impermanent loss.

• Arbitrage is a way to make money on the difference in the value of an asset in different markets. If in the DEX pool, ETH is cheaper than in the spot market of the centralized exchange, then the trader buys the asset cheap in the pool. Afterwards he sells it for more on the CEX.

Popular AMM platforms

Uniswap

Uniswap is one of the leading DEXs and also the first AMM on the market. Uniswap is powered by hundreds (if not thousands) of liquidity pools for various ERC-20 tokens, creating huge opportunities to generate income from providing liquidity.

Curve

Curve Finance is another protocol that allows you to exchange tokens and provide liquidity. Curve is focused on stablecoins as well as wrapped bitcoins on the Ethereum network. The platform minimizes intermittent losses by pooling stablecoins (for example, 3Pool provides liquidity in USDC/DAI/USDT tokens) and avoiding liquid pairs that combine volatile coins and stablecoins.

Balancer

The Balancer protocol is also an open source AMM, but unlike most other exchanges that use a 50/50 asset split to create liquidity pools, Balancer allows you to create pools of up to eight different tokens. These pools are automatically balanced according to smart contracts, reducing the risk of intermittent losses.

Conclusion

Cryptocurrency exchanges with AMM are one of the most important components of the DeFi space. They provide access to instant liquidity in an automated mode based on smart contracts, and reduce the risk of slippage. Such platforms are in demand among investors who want to earn passive income, because all services offer rewards to users for the supply of liquidity.

However, before using it, you need to evaluate all the pros and cons – consider the impermanent losses and the fact that decentralized exchanges are much less intuitive, so it might be best for beginners to start trading on centralized exchanges.