AMM systems are widely used in the DeFi industry, particularly on DEXs such as Uniswap, Balancer, Bancor, and Curve.

AMM uses liquidity in cryptocurrency public pools of multiple tokens locked in special smart contracts to create decentralized markets.

How did АММ emerge?

The Automated Market Maker (AMM) is an autonomous trading mechanism used by most of DeFi trading protocols. It facilitates the movement of capital and the execution of users’ exchange transactions on available crypto-asset markets.

Alan Liu, a member of the Gnosis project team, was the first prominent developer to discuss implementing AMM.

His ideas were outlined by Ethereum founder Vitalik Buterin on Reddit in 2016 and in his personal blog in July 2017.

This concept formed the basis of the Uniswap platform protocol, which received its first grant of $100,000 from the Ethereum Foundation. Vitalik Buterin also consulted with the Uniswap developers.

As a result of Uniswap, AMM gained widespread recognition. Simultaneously, one of the first successful AMM implementations is the Bancor Network platform, which raised $140 million through an ICO in June 2017.

How are liquidity pools related to AMM?

A liquidity pool — a type of storage of crypto-assets in the form of a smart contract — is required for AMM to function. A liquidity pool is typically made up of two crypto-assets that together form a market, similar to a trading pair on a centralized exchange.

Some pool participants invest their funds in order to earn money from exchange fees. These users are referred to as liquidity providers.

Another group is direct users of the decentralized exchange, who use one of the pools to exchange cryptocurrencies in the protocol (such transactions are known as “swaps”).

Consider what led to the formation of liquidity pools to gain a better understanding of them.

The first DEX exchanges were built on Ethereum and traded using the standard order book found on centralized exchanges. To be effective, such a trading mechanism must have extremely fast transaction processing speeds. Because transactions on a decentralized exchange are confirmed using a blockchain, the actual speed and capabilities of such a DEX were extremely limited. AMM enabled us to find a solution to this problem.

Thus, AMM is a fundamentally different way to create an asset market, as it is a formula or set of rules by which the protocol interacts with bids to buy or sell as well as user reserves.

How do liquidity pools work?

Pools can be made up of two or more assets. The Uniswap exchange, for example, can set up pools for paired tokens. You can create pools for three or more tokens on the Balancer platform. The Curve protocol is also intended for pools based on similar assets, such as ETH and wrapped token WETH or USDC and DAI. These pools’ operations are governed by AMMs.

To interact with liquidity pools, each of these AMM-DEXs may use its own formulas and rules. For example, the Uniswap protocol uses the following formula: x * y = k

In the equation, x and y represent the number of tokens available in the liquidity pool; k is a constant, called an invariant. In the case of Curve, the formulas x * y = k and x + y = k are used.

The formula x * y = k is also used by the SushiSwap and PancakeSwap projects, which are the most common type of AMM-DEX.

How is the pricing of an asset in the liquidity pool determined?

When liquidity is blocked in a pool, the pool’s provider receives special LP-tokens that confirm their participation in the pool. They can be represented by a promissory note, possession of which grants the right to receive commissions on exchange transactions and return their share of the pool.

LP-tokens are transferable crypto-assets that can be traded on the open market and invested in third-party DeFi applications.

A swap is the process of exchanging one asset for another via a liquidity pool. The process’s essence is to add only one asset to the pool, rather than two as in the case of LP. The pool charges a small fee for swaps, which is comparable to the fee for a deal at a centralized exchange, which is 0.1–0.3%. The commissions are divided among the liquidity providers in proportion to their participation in the pool.

Example

Let’s create a conditional liquidity pool for the ETH/USDC pair. At a price of 1 ETH equal to 2,000 USDC, it will be necessary to simultaneously lock in a smart contract any number of these two coins at a ratio of 1:2,000. At that price, there could be 100 ETH and 200,000 USDC in the pool.

The balance of assets in the pool is determined by their price. When a user decides to exchange 10 ETH using the pool described above, he will put his coins into a smart contract in a regular transaction. In exchange for his 10 ETH he will receive 20,000 USDC (not including exchange fees).

After that exchange, the pool balance will already be 110 ETH and 180,000 USDC. Consequently, the price of ETH in this particular pool will be about 1636 USDC instead of 2000 USDC in other markets. This situation attracts arbitrage traders, who profit from the imbalance by adding USDC to the pool until the market price reaches 2,000 USDC per ETH.

What are the АММ drawbacks?

Although AMM has been a game changer in trading and DeFi, it has a number of significant drawbacks. First, when making swaps with AMM, there is a high risk of price slippage. As a result, LPs face the risk of volatile losses, while regular users face the risk of Miner Extracted Value (MEV).

Other types of AMMs, such as the CowSwap project, which combines the development of AMM-Balancer and the Gnosis protocol, are being developed to mitigate such risks.

Second, unlike centralized exchanges, AMM allows you to place only one type of order. Limit orders and other types of orders, such as Stop Loss, are not permitted to be traded.

What is Impermanent Loss?

Impermanent Loss (IL) is a temporary or unrealized loss when using AMM-DEX to hold assets in the liquidity pool. The difference in price between the time the tokens are locked in the pool and the actual price at the time of holding is referred to as an IL. Unrealized losses are so-called because they are not fixed until liquidity is withdrawn from the pool.

As an example, let’s take the liquidity pool on the Uniswap exchange, which works according to the classic formula x * y = k:

This is a conditional example of a dramatic 50% increase in the price of a single asset, without taking into account the many trades by arbitrage traders and the time it takes to equalize the price

the price of the asset within the pool with the price at the centralized exchanges, where changes occur instantly.

When the market is “calm”, variable movements are added to the calculation of volatile losses, as described by StarkNet developer Peteris Erins in his blog. As a result of these forecast calculations, the Impermanent Loss value on a two-fold movement of the asset price will be about 5.7%. But this is only a projected value — potential “losses” are very difficult to predict.

How to reduce risks when trading with AMM?

Before you use a liquidity pool, you should calculate all of the possible commissions you will have to pay at the time of asset entry and withdrawal.

You must take into account the possibility of asset price movements in both directions. Some potential issues, such as non-permanent loss (IL) risk, can be predicted.

To calculate IL, you need to understand the nature of its origin. You can also use one of the non-permanent loss calculators available on the Internet.