The birth of Automated Market Maker is the biggest and most impressive step forward in the DeFi market. As investors gradually get bored of the crypto market with the appearance of too many centralized exchanges. AMM is considered an important piece for the decentralized economy - the real purpose of Blockchain - to develop further.
Table of contents
- What is Automated Market Maker (AMM)?
- Advantages and disadvantages of AMM
- How does AMM work?
- What is a Liquidity Provider?
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1. What is Automated Market Maker (AMM)?
AMM stands for Automated Market Maker - automatic market making mechanism. AMM is used in the decentralized exchange to form an AMM DEX.
Current DEX and CEX exchanges are using the Order Book method - where buyers and sellers actively negotiate suitable prices with each other - to conduct transactions. With AMM DEX, the exchange will use the AMM algorithm to automatically adjust the appropriate asset value for trading pairs in a Liquidity Pool.
2. Advantages and disadvantages of AMM
Advantages
Using an algorithm-based operating mechanism -> AMM solves the problem of price slippage when waiting for orders that occurs frequently on regular DEXs.
No intermediaries: AMM is designed to make transactions happen automatically, ensuring benefits and only needing the consent of both parties.
No need for KYC, investors just need to connect the wallet and use it freely.
Becoming a Liquidity Provider, you can receive an additional reward of the exchange's token or a part of the profit from the transaction fee of the Liquidity Pool.
Defect
If the liquidity value in the Pool is small -> The transactions will have high slippage.
The more Liquidity Providers join a pool, the smaller the profit received will be divided.
Impermanent Loss for Liquidity Providers.
Liquidity pool is quite easy to create -> There are many scam projects on the exchange.
3. How does AMM work?
How AMM works should pay attention to 2 points as follows:
Each liquidity pool on AMM contains 1 trading pair. For example, if you want to trade ETH for USDT, you need to find 1 ETH/USDT Liquidity pool to do so.
Anyone can become a Liquidity Provider providing liquidity to pools by depositing both cryptocurrencies contained in that Pool. All AMMs use a separate algorithm to balance the proportion of assets in a liquidity pool. With Uniswap and some AMM exchanges currently using the following equation to establish a mathematical relationship between two assets in the liquidity pool:
x * y = k
In there:
x: represents property A
y: represents the property B
k: a specific constant.
The above formula example for you to understand is as follows:
With ETH/USDT pool, when many investors buy ETH, they will add USDT to the pool and get the corresponding amount of ETH back. At this time, the amount of ETH in the pool will decrease, the price of ETH will increase according to the above balancing algorithm. Besides, as more USDT is added to the pool, the price of USDT will decrease. With the opposite case, when USDT is bought a lot, ETH price will decrease and USDT will increase.
In addition to the above formula of Uniswap and some AMM exchanges used, other AMM exchanges also have their own suitable price balancing formulas. For example, Balancer uses a more complex algorithm, allowing users to combine up to 8 crypto assets/liquidity pools.
4. What is a Liquidity Provider?
Automated Market Maker platforms use liquidity to maintain operations on the exchange. Because the aforementioned pools do not have enough reserve capital, they will be very susceptible to price slippage. And to minimize slippage, AMM DEXs incentivize users to pool assets so other users can trade with them. The providers are called Liquidity Providers. Liquidity Provider will receive a small part of the fees from the transactions made on the pool.
Solve the problem of slippage (Slippage) on AMM
As mentioned above, thanks to Liquidity Provider, AMM exchanges can minimize price slippage for coins/tokens per pool. So what is slippage here?
Slippage is the difference between the actual price after executing the trade and the initial expected price. Price arbitrage usually occurs when investors place a large order on illiquid coins/tokens, causing the price to increase significantly. Conversely, when a trader executes a large sell order, pushing the price down.
Therefore, to improve the problem of slippage, AMMs need to attract liquidity. The more liquid AMM DEX is, the less likely investors are to slip, leading to more liquidity. Besides, the AMM mechanism also limits the case that buyers withdraw all of their liquidity because this will cause the price to increase exponentially. For example, with AMM floor using the formula x * y = k is reduced to 0, then the formula will no longer make sense.
Yield Farming Opportunity on AMM for Liquidity Provider
As a Liquidity Provider, you can take advantage of yield farming opportunities to increase your profits. As noted above, AMMs will send LPs a small fee when providing liquidity to the pool, usually this fee will be distributed in the form of LP tokens. In some cases, you can deposit – or “stake” – this token into a separate lending protocol and earn additional interest.
This way, you will manage to maximize your earnings by taking advantage of the aggregation or interoperability of DeFi protocols.
So to become Liquidity Providers, you need to estimate how much profit you will gain and whether the Impermanent Loss is significant or not?
Impermanent Loss means impermanent losses. This term refers to the loss that occurs when accounting for the difference in profit between just holding the token and using that token to farm. To limit Impermanent Loss you can farm less volatile asset pairs and of course profit always comes with risk. When you choose safer, it means that the reward from the project's Reward for that Pool will also be lower.
The calculation process may take time, so I will introduce you to some websites that help make the calculation easier for the decision-making process to join the pool farm so that it is profitable. optimal profit.
- Impermanent Loss Caculator.
- WhiteBoardCrypto.
- DecentYields.
- Upoint.info.
