What is AMM DEX? Learn how AMM DEX works

What is AMM DEX?

AMM (Automated Market Maker Decentralized Exchange) is an automated mechanism based on smart contracts to provide liquidation. AMM DEX is a decentralized exchange that uses an automated market making mechanism. Everything happens automatically according to a script that has been designed and integrated into a pre-existing smart contract. These contracts automatically execute buy and sell orders based on pre-set orders without requiring the presence of a third party.

The AMM model is quite popular and is applied on decentralized exchanges (DEX) or other decentralized peer-to-peer (P2P) applications running on the Blockchain. Combined with the decentralized and unregulated nature of these platforms, the AMM model makes them even more accessible, allowing anyone to buy and sell cryptocurrencies without the need for intermediaries.

Components that make up AMM

A typical AMM model will include the following key components:

Liquidity Pool Pool

Liquidity Pools are funds raised from the community for each trading pair, such as the ETH- USDT pool. These pools provide liquidation to both buyers and sellers. As assets are bought and sold, smart contracts automatically adjust the ratio of assets in the pool to maintain price equilibrium. This way, assets in each pool are always available to serve any trading demand, allowing transactions to be executed continuously on the AMM protocol.

Liquidity LP

For liquidation pools to exist, the AMM model needs people to provide liquidation to the pool. They are called Liquidity Providers (LPs). LPs deposit idle cryptocurrency pairs into the pool’s smart contract. To incentivize LPs, AMMs reward them with a portion of the transaction fees generated on the AMM, usually distributed in the form of LP Token. LPs depositing assets to earn rewards is called yield farming.

Pricing algorithm

AMM does not require third-party intervention. It relies on mathematical algorithms to determine the price of assets. The price for each asset is calculated according to a pre-set formula, the most common of which is x * y = k . This formula helps maintain a balance between the assets in the pool. Some protocols like Curve Finance or Balancer use more complex formulas, but the main goal is still to determine a stable price for each asset in the liquidation pool.

Liquidity Pool

Liquidity Pools play an important Vai in the operation of AMM and DEX Liquidity Pool . They are where cryptocurrency pairs are stored to ensure liquidation for transactions. LP deposit their assets into the pool so that others can execute transactions. In return, they receive a portion of the transaction fees, typically 0.3%. These fees can be significant when calculated over an annual period, creating an incentive for users to provide liquidation.

Each Liquidity Pool contains a pair of assets, for example ETH/ USDT. When a user wants to trade ETH for USDT, they will interact with this pool, add one asset and withdraw another asset. The volatility in the pool will change the prices of the assets based on the equilibrium algorithm x*y=k .

The Role of Liquidity Pool

• Providing liquidation: Ensuring there are enough assets in the pool to meet users' trading needs, minimizing slippage.
• Incentivizing users to provide liquidation: AMMs often offer rewards in the form of trading fees and exchange Token to attract users to provide liquidation.
• Automated trading: Use algorithms to automatically adjust asset prices, ensuring trades are executed quickly and efficiently.
• Transparent and secure: The entire transaction and liquidation provision process is recorded on the blockchain, allowing users to check and verify every transaction.

How AMM works

The way AMM DEX works is based on an algorithm that automatically adjusts the asset value to suit the trading pairs in a Liquidity Pool. An important point is that each Liquidity Pool on an AMM contains a trading pair. For example, if you want to trade ETH for USDT, you need to find an ETH/ USDT Liquidity Pool to do so.

Anyone can become a Liquidity LP by depositing both cryptocurrencies in that pool. All AMMs use a unique algorithm to balance the ratio of assets in the pool. For example, Uniswap and some AMMs use the formula x * y = k, where x represents asset A, y represents asset B, and k is a specific constant.

When more investors buy ETH, they will add USDT to the pool and receive the corresponding amount of ETH in return, reducing the amount of ETH in the pool and increasing the price of ETH according to the balance algorithm. Conversely, when more USDT is bought, the price of ETH will decrease and USDT will increase. Other AMM exchanges like Balancer use a more complex algorithm, allowing up to 8 crypto/liquidity pool assets to be combined.

Advantages and Disadvantages of AMMs vs Traditional Exchanges

Advantage

• High security: No need to provide personal information when using automatic liquidation platforms, avoiding the risk of information leakage.
• Automated trading: Prices are determined algorithmically and executed automatically by smart contracts, no need to worry about placing orders incorrectly or waiting forever for orders to be matched.
• Low slippage: Trading price changes little between order placement and execution, except for liquidation Token .
• High transparency: All transactions are recorded on the blockchain and can be retrieved at any time.

Disadvantages

• Token Spoofing: The ease of creating liquidation pools makes the creation of fake Token pairs popular.
• High transaction fees: AMMs like Uniswap built on Ethereum are notorious for expensive Gas Price and frequent transaction congestion.
• Impermanent loss: Loss occurs when the Token value in the pool differs from the outside value, causing a loss to the depositor.

Stages of AMM DEX Development in Crypto

Early stage

Uniswap was one of the first to take AMMs to the next level, but Kyber Network (2018) and Bancor (2017) were the pioneers. Kyber Network operates on a centralized AMM model, while Uniswap adopted a decentralized AMM mechanism in November 2019, allowing anyone to contribute to liquidation pools. Curve Finance, launched in January 2020, focuses on Stable Assets such as Stablecoins, allowing users to trade with low fees and ushering in the Curve Wars era.

Read more: What is Uniswap (UNI)? All information about the Top 1 DEX exchange in the Uniswap market

Boom phase

AMM DEXs have become popular in many ecosystems. Uniswap allows for 50:50 liquidation provisioning, Balancer allows for up to 8 Token to be added, and BNB Chain’s PancakeSwap expands with features like Launchpad and Trading Competition. 1INCH, a Dex Aggregator, connects multiple liquidation pools to reduce slippage. Projects like Quickswap, Mdex, TraderJoe, and Matcha have all thrived on this model.

Selection phase

The emergence of many DEXs has created fierce competition. Projects must continuously innovate to survive. Uniswap, TraderJoe, PancakeSwap, Spookyswap are prominent names. Uniswap v3 was born with many improvements for liquidity providers and traders, helping Uniswap surpass its competitors in terms of Total Value Locked .

Saturation and finding gaps

During a downtrend, many projects struggle, including DEXs. The negative feedback loop results in fewer transactions, fewer fees, and less incentive for LPs. The value of liquidation Token decreases, reducing the incentive for LPs. This unsustainable model is exposed when a downtrend hits, raising the question of how to provide sufficient incentives while still generating surplus value for DEXs.

Example of how AMM DEX works

Opportunities and risks with AMM

Yield Farming Opportunity on AMM for Liquidity Provider

As a Liquidity Provider, you can take advantage of yield farming opportunities to increase your returns. AMMs pay LPs a small fee for providing liquidation to the pool, usually in the form of LP Token. In some cases, you can deposit – or “Stake” – these Token into a separate lending protocol and earn additional interest. This maximizes your earnings by leveraging the interoperability of DeFi protocols.

Impermanent Loss

Impermanent Loss is the loss that occurs when calculating the difference between holding Token and farming Token . To limit Impermanent Loss, you can farm less volatile asset pairs. However, profits always come with risks, and choosing safer means that the profits from the project's rewards will also be lower.

Slippage Problem on AMM DEX and How to Solve It

Slippage is the difference between the actual price after a trade is executed and the initial expected price. Slippage often occurs when placing a large order on liquidation coins/ Token , causing the price to increase or decrease significantly. To improve the problem of slippage, AMMs need to attract liquidation. The more liquidation an AMM DEX is, the less slippage investors experience, leading to more liquidation .

Slippage: Slippage occurs when trading a large amount of an asset changes the ratio of assets in the pool, resulting in a price that is different from the original market price. In the above examples, selling 5 ETH or buying 1000 USDT both result in slippage due to the change in the amount of assets in the pool.

Solving the price slippage:

• Increased liquidation in the pool: Greater liquidation helps reduce slippage as the change in asset ratio will be less when there is a large trade.
• Use DEX Aggregators: Platforms like 1INCH, Matcha, and Paraswap help find the best transaction paths, Chia transactions across multiple pools to reduce slippage.
• Price Stabilization Mechanism: Exchanges like Curve Finance use complex algorithms to keep prices stable, especially with stablecoins.
• Limit order trading: Allows users to buy or sell assets at a fixed price, avoiding slippage.
• AMM formulas are more complex: Exchanges like Balancer allow multiple assets and different weightings in a pool, which helps reduce slippage.

Summary

Automated Market Makers (AMMs) have revolutionized the DeFi market, with automated liquidation provisioning mechanisms and brokerless trading. With platforms like Uniswap, Curve Finance, AMMs allow users to easily trade and provide liquidation, while earning rewards from trading fees. Despite some challenges like slippage and impermanent loss, AMMs continue to grow and improve, creating an increasingly sustainable and efficient DeFi ecosystem.