What is Automated Market Making?

If you’ve been following the Decentralized Finance (DeFi) hype lately, I’m sure you must’ve come across Uniswap.

Everyone’s talking about it. And while they’re at it, they drop terms like Automated Market Makers (AMMs) every now and then.

Depending on how much you know about the DeFi space you may or may not know what that means. If you identify yourself with the latter and often find yourself wondering what AMMs are or what Automated Market Making is, this article is for you!

That said, if you already know what AMMs are, the article can be a good brush-up for you. We’re locked and loaded with facts so that you get the right information, always.

If you still don’t feel like reading the entire article or are short on time, here’s a quick rundown. Feel free to skip to the section(s) you find interesting!

  1. What is Automated Market Making?
  2. Why do we need Automated Market Making?
  3. What are the best Automated Market Makers?
    1. Uniswap
    2. Curve
    3. Balancer
  4. Why are Automated Market Makers gaining popularity?
  5. What does the future look like for Automated Market Making?
AM Making

What is Automated Market Making?

Traditional trading relies on human beings as market makers. It is humans who create order books that facilitate trade in traditional models.

In these order book markets, prices are entered in the order books. And since the order books are publicly accessible, all traders get to know about these prices. If a trader agrees to the price demanded by the other trader, the trade happens.

The only problem is that a person trying to sell something would try to set the highest prices for it. Likewise, a person trying to buy something would try to get it for as low a price as possible.

So, what you eventually get is a stalemate. Neither the buyer nor the seller would be ready to adjust prices. And because of that, the trade won’t happen.

To overcome this issue, traditional markets have traders who are ready to buy or sell a certain item or commodity at any given price. This helps them trade with the buyers seeking low prices as well as the sellers seeking high prices.

When these traders make a trade, they establish a market for that item or commodity. For that reason, this process is called market making. And the traders we’re talking about are called market makers.

While the traditional markets are making use of some of the advancements in technology, DeFi is taking it to the next level. DeFi is automating the process of market making with the help of lines of code called smart contracts.

This helped build Decentralized Exchanges (DEXes) that are secure and well-equipped to maximize the profits of the traders.

Some of the biggest names in the DeFi space for automated market making are Uniswap, Curve, and Balance. And we’re going to talk about each of them in detail. But before we get to it, let’s talk about why we need automated market making in the first place!

Why Do We Need Automated Market Making?

To answer why we need automated market making, we would need to travel back in time.

In case you’re wondering – no, companies from the DeFi space weren’t the first ones to come up with the concept of automated market-making.

Amongst the first ones to try and implement the concept of automated market-making were Shearson Lehman and Brothers. Surprised at how far back this goes? So was I when I first learned about it. There’s a good reason why the first instance of automated market-making dates back to that era.

There were great technological advancements going on back then. Moreover, trading at NASDAQ and the likes were on a rise. Yet entries in the order books were made by hand. In fact, there used to be rooms full of people doing this. 

As you can imagine, the chances of human manipulation in the market were high because of that. To reduce that and to bring liquidity to the market, they came up with certain rules. 

These rules attached actions to the shifts in the prices of assets. So, if the price of an asset decreases, certain action(s) would be performed. Likewise, some other predefined action(s) would be performed when the price of this asset increases.

While this worked great, technology was still evolving. And people were still trading during specific hours of the day.

When blockchain technology gained popularity, people thought of tackling certain issues with it. After all, it provided them with a market that was open all the time regardless of the day, week, month, or even year.

This forced existing trading models to change and for automated market making to evolve further. As of now, there are many Decentralized Exchanges (DEXes) that are using the concepts of automated market-making. And they’re coming up with more secure and user-friendly trading models.

Let’s talk about some of these DEXes.

What are the Best Automated Market Makers?

While there are many Automated Market Makers (AMMs) in the DeFi space right now, there are a few we believe are the best. We’ve chosen these AMMs based on solid facts as well as our experience on these platforms. So here they are:

1. Uniswap

We’ve talked a lot about this platform in our beginner’s guide to Uniswap. So we’re not going to get into much detail about it. That said, we’ll equip you with enough knowledge about it for you to understand what the platform is all about.

Uniswap is an Ethereum-based protocol created by Hayden Adams. The protocol provides automated liquidity. Launched back in November 2018, the protocol has gained quite a lot of popularity. In fact, it is one of the most (if not the most) popular AMM in the DeFi industry.

As an automated market maker, it sets a price to all tokens automatically. This means that buying and selling orders are no longer needed.

Uniswap ensures a fair market with the use of smart contracts for setting the prices of tokens. This makes the platform more secure, decentralized, and highly censorship-resistance.

Being a fair market is one of the reasons why it is the prime choice for a lot of people who are starting out with trading.

The best part of Uniswap is that its team is always working on improving the platform. In May 2020, the Uniswap team released V2 contracts on the mainnet. This offered users features such as flash swaps, price oracles, ERC20/ERC20 token pairs, etc.

Don’t worry if you were unable to understand what the last few words meant. It’s all present on our beginner’s guide to Uniswap. So please check it out to understand these concepts better.

2. Curve

Curve aggregates stablecoin tokens into liquidity pools. This allows users to swap their tokens at a low slippage. Using its lending protocols, the platform allows liquidity providers to earn stable trading fees and interests.

When you deposit your stablecoins into the pool, you receive an equal share of pool tokens. So far, it’s pretty similar to Uniswap, right?

Now when you need to withdraw from the pool, you’re asked to choose the stablecoin you wish to withdraw. This is the biggest difference between Curve and Uniswap. The latter doesn’t allow for this to happen.

Curve allows you to provide liquidity without having to source a share of every stablecoin in the pool.

Curve also gives liquidity providers a small deposit bonus when they provide liquidity for the stablecoin that has the smallest share in the pool. This gives them an incentive to maintain a healthy liquidity utilization ratio.

The lending protocols that Curve uses are Compound, dYdX, and Aave.

3. Balancer

Balancer is one of the most innovative AMMs out there. It has introduced a lot of new features to tackle the issues that the DeFi community faces regularly.

From multi-token pools to dynamic pool fees and custom pool ratios, Balancer has brought a lot to the table.

The platform boasts of allowing the creation of pools of up to 8 tokens. This feature allows it to be an automated portfolio manager acting as an index.

Based on the volatility and the condition of the market, it allows for the pool fee to be adjusted. This is another feature that was previously unheard of.

Why are Automated Market Makers Gaining Popularity?

The reason why AMMs are gaining popularity is that they give users exactly what they need.

Traders can use AMMs for instantly trading with their favorite cryptos that they bought at market price. They don’t have to wait for their buying or selling order to find a willing trader. This increases the liquidity of the cryptos they’re holding.

Liquidity providers, on the other hand, use AMMs to earn trading fees from every trade. Sure, they have to deal with impermanent loss every now and then. But they still end up making a considerable amount of money by providing liquidity.

Moreover, these platforms are easy to use and are highly secure. So even beginners can start using these platforms without having to worry about losing their cryptos. This makes new and experienced traders and liquidity providers flock to these platforms.

What does the Future Look Like for Automated Market Making?

With so many AMMs in the market, there’s a lot of competition. And with competition comes improvement—a fight to stay relevant.

For this very reason, it is safe to say that the future of Automated Market Making is going to be bright. Moreover, as technology evolves, it is going to make way for more innovation to come to this sector.

Whatever happens, the future of Automated Market Making is going to be an interesting one.

Before You Go…

Automated Market Making is here to stay. With so much to offer and with so many AMMs working on making it better, it has a bright future.

However, there’s no denying that it has its own shortcomings. So the grass isn’t all green on this side either.

On the positive side, a substantial part of the DeFi space is working on fixing those issues. So there’s a lot of potential in it.

That said, this article is not a financial gospel. So if and when you invest in AMMs, do so at your own risk.