Automated market makers are a type of decentralized exchange protocol that determines the price of a token through formulas. These change with each protocol. There are different AMMs that use different formulas, but they have one thing in common and that is that they all set prices through algorithms.
The operation of an AMM is similar to that of an order book exchange, i.e. there is no need to trust the trader because all you have to do is interact with a smart contract. An AMM is a peer-to-peer transaction happening through exchanges between users and contracts.
A liquidity pool happens when users trade a huge amount of funds. When they provide liquidity, they get rewards for their trades.
To calculate the price, a formula resembling a parabola will do it, where it shows that the slippage for small orders will be low and for large orders, it will increase considerably.
An impermanent loss occurs when a number of tokens arise and the relationship to the price changes after they deposit. Depending on the change, the loss will be smaller or larger. For this reason, AMMs have more optimal performance for stable currencies.
Losses can recover if the assets returns to the same prices they had at the initial deposit. If, on the other hand, the investor withdraws his funds at a different ratio to the original one, these losses will be permanent.
Main Advantages and Disadvantages of AMMs
On the one hand, some advantages of AMMs are:
-First, MMAs are decentralized, so there is no need for a central authority.
-There are no fees or criteria for admission, anyone can create a liquidity pool for a token.
-Users do not need to create accounts or KYC verifications, so they only need their wallet address.
On the other hand, some of the disadvantages of AMMs are:
-There is the possibility of users losing money because of complicated interactions by smart contracts, so AMMs can suffer from weaknesses or attacks.
-In order to correct the price of assets, arbitrage traders are indispensable in AMMs.
Automated Market Maker (AMM) Conclusion
In conclusion, AMMs are necessary for the DeFi market, where anyone can easily and efficiently build markets. Although still under development, some such as Uniswap and PancakeSwap are improving their platform and it is estimated that innovative MMAs will be created in the near future. What will provide DeFi users will be lower transaction fees and lower liquidity.
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