There are two important components in DeFi that have disrupted the finance industry. They are liquidity pools and AMM (Automated Market Makers). They have been disruptive in the way they provide and deliver financial services. For the most part, they are just code that runs in software called smart contracts. They execute on top of the Ethereum blockchain, which provides a platform for decentralized applications. These are financial instruments of a new type of system that are blockchain-based.
Automated Market Makers (AMM)
An AMM or Automated Market Maker is the DeFi version of the traditional market maker brokerage houses. There are big differences between them. Both market makers are providers of liquidity. Market makers are actual companies or members of an exchange that handle buy and sell order books. AMM runs as smart contracts on a blockchain, and automates the order book system. The order matching is done automatically by an AMM, while on exchanges the market maker has to process the order books. The latter can take longer time, while the former provides efficiency.
The primary purpose of an AMM is to eliminate third parties so that users can trade directly from their digital wallets. Users do not need to register with a broker to buy and sell cryptocurrency. An AMM handles all matters of trading, at market value through price discovery. Traditional market makers take a cut or “spread” from the orders they process at a much higher cost since they are absorbing the risk for the user. An AMM can do the same, but the process is different.
AMM are implemented as protocols that run from computer code. They hold no capital, are always open (no closing time) and most offer users real time prices in the exchange of cryptocurrency. They fulfill orders from a liquidity pool, which holds the cryptocurrency the user needs to exchange. Thus, the AMM does not need to locate another user who wants to sell, making it faster to swap between cryptocurrency. AMM also cannot manipulate or control trading since they run on a decentralized network. Thus they are suitable for trustless trades for any party. Examples of AMM are Uniswap, Bancor and Curve.
Liquidity Pools
Like AMM, liquidity pools are also implemented as smart contracts. Their purpose is to hold the cryptocurrency (e.g. tokens, coins) used for exchanges made by AMM. This facilitates trading on what are called DEX (Decentralized Exchanges) which are the services that an AMM provides. A liquidity pool allows the participation of users called liquidity providers. This allows liquidity provision by locking a cryptocurrency pairing and in return the users receive returns from transaction fees. The users are also issued a token that is a ratio of their contribution to the liquidity pool. When a user wants to remove their liquidity, they must use the token to unlock their funds along with any fees collected.
Liquidity is important because this is what allows trades to be made. If one user needs to trade Ethereum’s ETH for another token like the stablecoin USDC, there has to be a certain amount available on an exchange. Liquidity pools keep a locked supply of these tokens so that they will be available when there is an order. It is the AMM, through incentives to liquidity providers, that keep the liquidity flowing. The AMM also keeps a certain ratio for token pairings in order to maintain liquidity.
Summary
AMM are smart contracts that provides new ways for financing in DeFi. They make use of liquidity pools to help facilitate trades with cryptocurrency. AMM has automated the order book system, by matching buyers with sellers and handling the issues with price volatility without human intervention. An AMM actually consists of not one but multiple liquidity providers, who can be anyone that provides a token pair to a liquidity pool. In return for liquidity provision, the liquidity providers earn from transaction fees. The AMM runs as a smart contract on top of the Ethereum blockchain in most cases, but there are other platforms available (e.g. Binance Smart Chain).
DeFi is building bridges between traditional and decentralized finance. Liquidity sources like Bitcoin ATM (BTM) form a part of the ecosystem. Users can cash in to a BTM for cryptocurrency that can be used to provide liquidity. AMM does not require user documents to become a liquidity provider, so it is open to all. What is important to understand is the risk involved with AMM and liquidity pools. Since they are decentralized, the users have to manage their own risk. There are users who are ready to manage the risk for higher rewards.
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Disclaimer: The information provided is for reference and educational purposes only, and is not financial advice. Always DYOR to verify information.
