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EducationalMay 10, 2021

What Is an Automated Market Maker (AMM)?

Shubham Goyal
Chief Technology Officer
May 10, 2021

The DeFi space continues to grow with every passing day and the total value locked in DeFi stands at over $81 billion as of the beginning of May, 2021. Amidst this growth, the AMM or the Automated Market Maker has become an aspect of the DeFi world a lot of investors have become interested in, resulting in AMM protocols like Uniswap witnessing competitive volumes, and high liquidity.

Indeed, AMMs have become an essential part of the DeFi space. It’s why you should be aware of their workings and other details regarding automated market makers if you plan to enter crypto trading markets. So in this post, we give you everything you need to know about AMMs!

What is an Automated Market Maker (AMM)?

AMMs are a financial tool that’s a specialty of the Ethereum blockchain and the DeFi space in general. The concept was brought about from a blog post about “on-chain market makers” from the founder of Ethereum, Vitalik Buterin. An automated market maker is a decentralized exchange that makes use of a mathematical formula to decide the prices of various cryptocurrencies. Automated market makers allow crypto coins to be exchanged in a permissionless and automatic fashion by using liquidity pools (more on that later), as opposed to the traditional marketplaces of buyers and sellers.

Automated market makers have smart contracts which can create stores of crypto tokens (also known as liquidity pools), and the tokens are automatically traded out by an algorithm instead of an order book. The mathematical formula AMMs use to determine the exchange ratio between various crypto tokens within a liquidity pool can vary, since different AMMs have different formulas for their specific use cases. However, the most common formula was proposed by Vitalik, which is:

tokenA_balance * tokenB_balance = k

Here, ‘k’ is a constant, symbolizing the pool’s total liquidity must always stay the same.

How Does an Automated Market Maker (AMM) Work?

A centralized cryptocurrency exchange generally uses an order book to match buyers with sellers. What automated market makers do is decentralize that process, and provide any user with the opportunity to create a blockchain market. Similar to an order book exchange, an AMM also has trading pairs. However, in case of an automated market maker, you do not need a counterparty to initiate or complete a trade. The trades simply happen between users and smart contracts, so you can get a smart contract to create a market for you specifically.

An important part of an AMM’s working is the liquidity pool. Liquidity pools, as mentioned before, are reserves of crypto coins kept locked in smart contracts. With liquidity pools, users can initiate transactions on a blockchain on their own and trade one token for another, all without requiring a centralized authority figure or any third party to intervene.

The usual liquidity pool has two different crypto tokens to create a trading pair. These trading pairs can be formed with any two cryptocurrencies so long as they are on par with the ERC-20 token standard.

So, for example, suppose you choose to sell your crypto through an AMM. in this case, the smart contract first sends your tokens across to a liquidity pool that contains the kind of crypto you own and another that you want. The smart contract swaps your tokens out for the other token in that pool. The amount of that other token you would receive is decided by the AMM’s mathematical formula.

Apart from trading, AMMs also give you the opportunity to be an LP or a liquidity provider. These LPs are users who provide liquidity to the liquidity pools on the AMM. Therefore, automated market makers let any user become a market maker, and earn a portion of the trading fees the platform receives as reward for providing liquidity.

The AMM Pools on Delta Exchange:

On Delta Exchange, the AMM used by the liquidity pools running on the platform does the following:

  • collects information from a broad number of sources to decide upon a trading strategy,
  • keeps and updates multiple buy and sell orders in the order book,
  • efficiently distributes capital at different levels of the order book and between contracts,
  • Reacts to and forecasts market conditions to make adjustments to its trading strategy,
  • Can decide to show only bid, only offers, or to stay out of the market, and decrease or hike up leverage,
  • And finally, has the intelligence to manage the risk of open positions.

The Delta Exchange AMM is designed similarly as the market making firms in TradFi, instead of the traditional DeFi AMMs. As for the features, here are some distinct characteristics the Delta Exchange Automated Market Maker pools possess:

  1. The pools comprise of only one single crypto (BTC or USDT)
  2. One pool can be used to make multiple markets. So a BTC pool can be used to create markets on all BTC settled contracts, increasing capital efficiency.
  3. The built-in leverage in derivatives enhances the trading profits of the market maker.
  4. A Delta AMM pool only takes in capital it can utilize profitably. The capital requirement is lower when compared to spot market trading, because of the leverage.
  5. The code of the Delta AMM is situated in the same private cloud as the matching engine of the platform. Therefore, the AMM pools enjoy a latency advantage over any external market makers.
  6. Liquidity providers on the platform get three sources of revenue; they can profit from the market making gains, their portion of the trading fees accumulated on Delta, of course, and from the mining of DETO – the native token of the exchange platform.

To find out more about the Delta AMM, give this post a read!

On Delta Exchange, you can trade a range of crypto derivatives in India. To know more about the world of DeFi, crypto derivatives trading, and cryptocurrencies in general, don’t forget to give our blog a visit!

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