Automated market-making protocols, such as Uniswap, have gained a lot of traction in the past year, a very positive development for many smaller projects to gain exposure without being listed on a traditional centralized exchange (CEX). In this article, we’ll be discussing automated market-makers (AMMs).
Before I explain AMMs, let me explain market-making: the key here is liquidity – liquidity is a crucial feature of any financial asset, otherwise known as the ability to buy or sell an asset without drastically impacting the price. The primary reason behind the importance of liquidity is that liquid assets are generally less risky and more attractive to the investor, financially speaking. Simply put, a market maker is an entity that quotes buy and sell prices and uses either their capital or capital from other investors to provide liquidity.
What Is an Automated Market-Making Protocol?
In an earlier article, I briefly explained decentralized finance (DeFi) and how it has become a movement to transform financial services we use every day – like savings accounts, investments, or just for hedging into safe, open, and secure protocols without any intermediaries. The main ingredient to DeFi applications are what's known as smart contracts, which are programs that automatically execute a task or a process when certain conditions become met.
Now, we are ready to explain AMM protocols.
AMM protocols are smart contracts that automatically provide a price to an exchange for a digital asset. AMMs have a couple of peculiar features – for instance, the first being that they usually provide a single price-feed to a DEX for just two digital assets and not a full order book. Secondly, the price that an automated protocol provides is usually well-known and deterministic.
The third particular feature of AMM protocols is that they do not have capital themselves, but they have to gather it from third-party participants through liquidity pools (LPs). Participants are incentivized in exchange for supplying the capital to those liquidity pools through a shared percentage of every trade fee.
Brief History of Automated Market Making
AMMs might seem quite innovative and new, but it turns out we have had similar attempts in the past. In traditional financial markets where people used similar methods to exchange assets in the early 90s, the U.S. equity markets implemented a so-called small order execution system (SOES) that mandated market makers to quote prices at predetermined levels for specific stocks. Unfortunately, the small-order execution system was not a success, as traders easily arbitraged market makers that participated in this particular program, and those traders who took advantage of this arbitrage opportunity would come to be known as the SOES bandits. Despite this, many users in the DeFi space welcome the positive developments of the automated market-making protocol.
It is obvious the automated market-maker has solidified a clear place in the future of finance. The future of software applications operates in a decentralized fashion, without the insufficiency of a middleman or third-party handling transactions in return for a cut. This model will likely reshape the world of fintech, where applications operate without any human interference or the need to rely on human input to keep running.
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