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Automated market maker (AMM) is a computer program that actively provides liquidity in a market by automatically buying and selling assets in accordance with pre-determined rules. This type of market maker uses algorithms to set prices and execute trades based on the supply and demand of the assets they trade.

Automated Market Maker (AMM) has been around for a while, and many people are still unaware of its potential. To fully understand the concept of AMM, we must first understand what a market maker is. In this article, we will dive deep into the world of AMM to explain everything you need to know about it.

What is an AMM (Automated Market Maker)?

An AMM (automated market maker) is a computer program that actively provides liquidity in a market by automatically buying and selling assets in accordance with pre-determined rules. This type of market maker uses algorithms to set prices and execute trades based on the supply and demand of the assets they trade. 

what is amm
What is an AMM (Automated Market Maker)?

Automated market makers are often used in electronic trading platforms, such as stock exchanges, to provide liquidity and make sure that prices do not become too volatile. They are also used in cryptocurrency exchanges to provide liquidity for digital assets. AMMs help to ensure that buyers and sellers can always find counterparties for their trades. 

AMM has been used in traditional financial markets for many years but has only recently been applied to cryptocurrency markets. AMM is appealing to exchanges and traders because it eliminates the need for a centralized order book. This means that there is no need for a third party to match buyers and sellers, which can save on costs and increase efficiency. 

Cryptocurrency exchanges that use AMM include Uniswap, 1inch, Pancakeswap,… These exchanges have all seen significant growth in trading volume and liquidity since adopting AMM.

How does AMM work?

how amm works
AMM uses algorithms to set prices and execute trades

AMMs use algorithms to set prices and execute trades. These algorithms take into account the supply and demand of the assets in the market, as well as the prices of other assets. AMMs use this information to set prices that are fair for both buyers and sellers. 

  • When a buyer wants to buy an asset, they will send a buy order to the AMM. The AMM will then match the buyer with a seller and execute the trade. The AMM will take a small fee for providing this service. 
  • When a seller wants to sell an asset, they will send a sell order to the AMM. The AMM will then match the seller with a buyer and execute the trade. The AMM will take a small fee for providing this service. 

AMMs can be used to trade a wide variety of assets, including stocks, bonds, commodities, and cryptocurrencies. 

Automated Market Maker Formula

Overall, AMM is a very simple model. There is a constant value associated with 2 different tokens in a decentralized exchange

amm formula
AMM Formula

When someone wants to buy or sell one of these 2 tokens, they do so through the pools that the AMM has. 

These pools hold both of the tokens and are always equal to each other in value. The oracle determines the amount of each token in each pool. When someone wants to buy or sell, they specify how much of each token they want and the trade is executed automatically.

If someone wants to buy one token, they will send their tokens to the pool that holds the other token. The AMM will then take an equal amount of both tokens out of the pool and give them to the person who wanted to buy them. If someone wants to sell one token, they will send their tokens to the pool that holds the same token. The AMM will then take an equal amount of both tokens out of the pool and give them to the person who wanted to sell them.

The key thing to remember is that the value of each pool is always the same. So if someone buys one token, the value of the pool that they bought from decreases and the value of the pool that they sold to increases. But overall, the value of both pools stays the same.

The oracle is constantly updating the prices of each token in each pool so that they are always equal. This means that if the price of one token goes up, the price of the other token in the pool will go down so that the overall value of the pool stays the same.

Difference between Automated Market Maker vs. Order book

When it comes to trading cryptocurrencies, there are two main types of exchanges: those that use order books, and those that use AMMs (automated market makers). Both have their own advantages and disadvantages, so it's important to understand the difference before choosing an exchange.

Order book exchanges are the more traditional type of exchange, where buyers and sellers place orders that are then matched by the exchange. This type of exchange is usually more suited for traders who know exactly what they're looking for, as they can specify the price they're willing to pay or accept. However, order book exchanges can be subject to manipulation by large traders, known as "whales", who can move the markets by placing large orders.

AMM exchanges, on the other hand, use algorithms to automatically match buyers and sellers. This type of exchange is more suited for those who are just looking to buy or sell a particular cryptocurrency, as they don't have to worry about finding a matching order. However, AMM exchanges can often charge higher fees than order book exchanges, as they need to make a profit from the spread between the buy and sell prices.

So, which type of exchange is better? It really depends on your trading style and what you're looking for. If you're a more experienced trader who knows exactly what you want, then an order book exchange may be better for you. However, if you're new to trading or just want to buy or sell a particular cryptocurrency, then an AMM exchange may be a better choice.

Understanding AMM (Automated Market Maker)?

Liquidity pools are often used in cryptocurrency to provide traders with the ability to buy or sell large amounts of digital assets quickly and easily. However, there are several disadvantages and advantages to using liquidity pools that traders should be aware of before using them.

Advantages of AMMs

Here are some benefits of using AMMs:

  • Providing liquidity in markets. This means that there are always buyers and sellers available to trade assets. 
  • Helping to keep prices stable. They do this by buying and selling assets when there are large swings in price. This helps to prevent prices from becoming too volatile. 
  • Helping to ensure that buyers and sellers can always find counterparties for their trades. 
  • Taking a small fee for their services. This fee is often much lower than the fees charged by traditional market makers. 

Risks of AMMs

What are the risks of using AMM? There are some risks associated with using AMMs: 

  • Being reliant on algorithms. These algorithms can sometimes make mistakes. 
  • Can be hacked. This could result in the loss of assets if the pools are exploited by hackers.  
  • Impermalent Loss: This type of loss is inherent in any trading or market-making strategy that involves holding two assets simultaneously. It occurs because when the price of one asset falls, the value of your position in that asset also falls. When you are providing liquidity to an AMM, the portion will lose value compared to holding. 
  • Finally, liquidity pools can also charge high fees. Some exchanges or pools may charge a percentage of the trade value as a fee. This can eat into profits and make it more difficult to make money from trading digital assets.

Overall, automated market makers are a useful tool for providing liquidity and stability in markets. However, there are some risks associated with using them. These risks should be considered before investing in assets that are traded by AMMs. 

What is AMM Liquidity Pool?

amm liquid pool
Liquidity Pool is a collection of assets that users can buy and sell

Liquidity refers to how quickly an asset can be bought or sold in the market without affecting the asset's price. A liquidity pool is a collection of assets that are easily converted to cash. 

In the cryptocurrency world, a liquidity pool is a group of digital assets that can be traded for other cryptocurrencies or fiat currencies. Liquidity pools provide investors with a way to buy and sell cryptocurrencies without having to go through a centralized exchange. 

Liquidity pools are often created by large cryptocurrency exchanges as a way to provide their users with more options for trading. These pools can also be created by groups of investors who want to trade a specific digital asset. 

The size of a liquidity pool can vary. Some may only have a few million dollars worth of digital assets, while others may have billions. 

Investors who are looking to trade a specific cryptocurrency may want to check if there is a liquidity pool for that currency. This can provide them with more options for trading and may help them get the best price for their trades.  

There are a few variations of liquidity pools in the market which will be briefly explained shortly.

Fed Price Reserves

Some cryptocurrencies use a liquidity pool to help stabilize the price of their coin. This is especially important for those coins that do not have a central authority, like Bitcoin. The Fed price reserves in the liquidity pool are used to help maintain the value of the coin and keep it stable. 

If the price of the coin starts to fall, the reserves can be used to buy up coins and prop up the price. Similarly, if the price starts to rise too fast, the reserves can be used to sell off some of the coins and bring the price back down. This system helps to keep the value of the coin more stable and makes it less volatile.

Automated Price Reserves

Automated price reserves in the liquidity pool are a type of insurance against value fluctuations in the cryptocurrency market. By holding coins in reserve, you can be sure that their value will not drop to zero, no matter how low the overall market value of cryptocurrencies falls. This makes them an essential part of any serious investor's portfolio, and a great way to protect yourself from financial ruin.

If you're thinking about investing in cryptocurrencies, then you should definitely consider using automated price reserves in your liquidity pool. They offer a valuable safety net that can keep your coins safe during times of market turmoil, and ensure that you always have access to your money.

Bridge Reserves

Bridge reserves are a type of cryptocurrency reserve that is used to provide liquidity to a bridge pool. Bridge reserves are typically held in a trust account or other type of escrow account, and they are used to back the coins that are deposited into the pool. The purpose of holding these reserves is to ensure that there is always enough liquidity in the pool to cover withdrawals and to provide protection for the users of the pool in case of a sudden drop in the value of the underlying assets.

Bridge reserves can be used to cover a variety of different types of risks, including market risk, credit risk, and operational risk. In general, the more volatile the asset class, the higher the number of bridge reserves that should be held. For example, of reserves that should be held. For example, if a pool focuses on volatile assets such as Bitcoin, it would likely hold a higher percentage of its assets in reserve than a pool that invests in more stable assets such as stablecoins.

Popular Automated Market Maker Platforms

Uniswap is the largest decentralized exchange operating on the Ethereum blockchain. It allows users anywhere in the world to trade crypto without an intermediary. Uniswap pioneered the Automated Market Maker model, in which users supply Ethereum tokens to Uniswap “liquidity pools” and algorithms set market prices based on supply and demand.

uniswap amm
Uniswap is the largest decentralized exchange on Ethereum

Curve is a decentralized exchange (DEX) running on Ethereum. It's specifically designed for swapping between stablecoins. All you need is an Ethereum wallet, some funds, and you can swap different stablecoins with low fees and slippage.

Conclusion

Automated market makers play an important role in the functioning of decentralized exchanges, as they are often the only source of liquidity on these platforms. The presence of automated market makers helps to mitigate these problems by providing a constant source of liquidity. Therefore, AMMs will always be a necessary factor in cryptocurrency markets.

I hope you enjoyed reading this article. If you have any questions or comments, please feel free to leave them below and don't forget to join Coin98 Community for more valuable insights and cryptocurrency discussions.

As always, thanks for reading!

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