...by Daniel Szego
"On a long enough timeline we will all become Satoshi Nakamoto.."
Daniel Szego

Friday, March 17, 2023

DEFI Automated Market Making (AMM)

Automated market making is a system of trading that uses computer algorithms to create and maintain a market for a particular asset. It is often used in the context of cryptocurrency exchanges and decentralized finance (DeFi) platforms.

In an automated market making system, there is no central authority setting the price of the asset being traded. Instead, the system uses a mathematical formula to determine the price based on the current supply and demand for the asset. The formula takes into account the current price, the amount of the asset being traded, and the liquidity of the market.

Automated market making systems typically use liquidity pools to facilitate trades. A liquidity pool is a collection of assets that is used to provide liquidity to the market. Traders can buy or sell the asset to the pool at the current price, and the pool adjusts the price based on the demand for the asset.

Automated market making can provide benefits such as continuous liquidity and faster trading. However, it can also be subject to volatility and price manipulation, and it may not be appropriate for all types of assets or trading strategies.

There are several major automated market making (AMM) algorithms used in cryptocurrency exchanges and decentralized finance (DeFi) platforms. Some of the most common ones include:

  • Constant Product Market Maker (CPMM): The CPMM algorithm, also known as the Uniswap algorithm, is one of the most widely used AMM algorithms. It maintains a constant product of the two assets being traded, which means that the price of the assets changes as the supply and demand for them change.
  • Constant Sum Market Maker (CSMM): The CSMM algorithm maintains a constant sum of the two assets being traded. It is similar to the CPMM algorithm, but instead of maintaining a constant product, it maintains a constant value.
  • Weighted Constant Product Market Maker (WCMM): The WCMM algorithm is a modification of the CPMM algorithm that allows for different weights to be assigned to each asset being traded. This allows for more control over the price of the assets and can be useful for trading pairs with uneven liquidity.
  • Bonding Curve Market Maker (BCMM): The BCMM algorithm uses a bonding curve to determine the price of the asset being traded. A bonding curve is a mathematical formula that relates the price of an asset to the amount of the asset in circulation.
  • Hybrid Market Maker (HMM): The HMM algorithm combines elements of multiple AMM algorithms to create a more flexible and customizable market making system. It allows for different algorithms to be used in different market conditions and can adapt to changing liquidity and demand.

These are just a few of the major AMM algorithms used in cryptocurrency exchanges and DeFi platforms. New algorithms are being developed all the time as the technology continues to evolve.

While automated market making (AMM) has many benefits, there are also several potential disadvantages to consider:

  • Impermanent Loss: One of the biggest risks of AMM is impermanent loss, which occurs when the price of one asset in a trading pair changes relative to the other asset. This can lead to losses for liquidity providers who are supplying assets to the liquidity pool.
  • Limited Price Discovery: Since AMM algorithms use mathematical formulas to determine prices based on supply and demand, they may not always provide accurate price discovery for the assets being traded. This can lead to price volatility and fluctuations.
  • Vulnerability to Price Manipulation: AMM algorithms can be vulnerable to price manipulation, especially in illiquid markets. This can lead to market inefficiencies and unfair trading practices.
  • Limited Asset Support: Not all assets may be suitable for trading on AMM platforms, especially assets with low liquidity or high volatility. This can limit the availability of certain assets on the market.
  • Slippage: When trading large volumes of assets, slippage can occur, which means that the price of the asset can change significantly from the time a trade is initiated to the time it is executed. This can result in unexpected losses or gains for traders.

Overall, AMM has several potential drawbacks that should be taken into consideration when using this trading method. However, many of these disadvantages can be mitigated through careful risk management and choosing a reputable platform with a well-designed AMM algorithm.