The Ultimate Uniswap Guide: Understanding the AMM Algorithm

The AMMs also benefit the liquidity provider, as they get a fraction of the fees paid on transactions in the pool. Balancer is also one of the first AMM pools to experiment with liquidity mining. The protocol’s token, BAL, is distributed by the proportion of liquidity provided to the approved token pools. The distribution rate and approved tokens are actively discussed in governance. It’s important to note that the Kyber Network fee structure recently went through a complete overhaul. what is an automated market maker Throughout most of the protocol’s history (FEB JUL 2020), the fee structure was a simple 70% burn and 30% rebate to dapps and liquidity providers.

What is the Ethereum Virtual Machine (EVM)?

Furthermore, you will need to ensure that you don’t leave a trail of your activities, exposing yourself to exploiters. To manage these https://www.xcritical.com/ issues, consider revoking access to exchanges and dApps you no longer using a revoking tool. Automated Market Makers (AMMs) are subject to several restrictions, and the idea is still relatively in its infancy. Still, it has helped the market advance considerably over the years.

Understanding automated market makers

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The Appeal of Uniswap Automated Market Maker – Is It Really Worth It?

The smart contracts monitoring this formula and implementing the price change act as the market makers. You may have come across Uniswap quite often, considering how it is among the most well-funded DeFi protocols out there. Despite what you may have heard, Uniswap is an automated market maker (AMM) as well as a decentralized exchange – and quite a popular one. Recall that a pool is created through the combination of two tokens of proportional value. Each time that a user deposits token pairs in the pool, he gets a share of it.

The Risks Associated With Uniswap

While seemingly a Uniswap copycat, SushiSwap introduced the idea of yield farming in the decentralized exchange space. Yield farming is the idea of staking cryptocurrency assets into platforms in return for payouts over time, popularised by the likes of Compound, an algorithmic, autonomous interest rate protocol. A liquidity pool refers to a digital pool of crypto assets present within a smart contract on a blockchain. These pools typically have two tokens, but in some instances, they may have more than two tokens. The supply-demand ratio of cryptocurrency trading pairs determines their exchange rates. For example, if a token’s liquidity supply exceeds demand in the liquidity pool, it will lead to a fall in its prices, and vice versa.

Solana vs Ethereum: What’s the biggest difference between SOL and ETH?

Uniswap, Curve, and Balancer are prominent first-generation automated market makers, but they are not without their defects. DEXs reward users with a portion of transaction fees and, at times, additional governance tokens for providing liquidity. AMMs work by replacing the traditional order book model with mathematical formulas and logic wrapped in smart contracts. This article explains what automated market makers are, how they work, and why they are critical to the DeFi ecosystem.

Automated Market Maker Variations

And V3 offers concentrated liquidity, a feature that lets liquidity providers earn similar trading fees at lower risk, since not all their capital is at stake. As discussed, Uniswap’s operating protocols are not the same as other exchanges, especially centralized exchanges. Instead of the price of a cryptocurrency being determined by an order book (demand and supply, in essence), Uniswap uses smart contracts to determine the token price.

Liquidity Pools and Liquidity Providers

• The liquidity in the smart contract still has to be provided by users called liquidity providers (LPs).
• The innovation in that AMM introduces is the removal of a central market maker and converting what was a once a one-sided market into a two-sided market of traders and liquidity providers.
• This is how an AMM transaction works and also the way an AMM acts as both liquidity provider and pricing system.
• The difference is that smart contracts “make” the market instead of humans or centralized exchanges.
• As your pool grows, consider automating it, as it will become overwhelming fairly quickly.

SushiSwap managed to lure Uniswap LPs to the new SushiSwap protocol by offering SUSHI token rewards on top of attractive trading fees. Synthetix is a protocol for the issuance of synthetic assets that tracks and provides returns for another asset without requiring you to hold that asset. The following picture illustrates the ratio of cat tokens required for dog tokens. We will explore how all of these AMM protocols deal with impermanent loss in more detail next.

Since its launch in 2020, Curve has emerged as the leading decentralized exchange market for stable assets. For token pairs with high liquidity and large pools, fees (trading price spreads + transaction fees) are often comparable to centralized exchanges. For illiquid token pairs, centralized exchanges offer better spreads. Liquidity pools are a big pile of funds that traders can trade against and liquidity providers are those who add funds to liquidity pools. In return for providing liquidity to the protocol, Liquidity providers earn fees from the trades that take place in their pool.

This has yet to be activated, as it is currently pending the development of a protocol governance system. The best part of all is that it’s likely that more and more people will see the merits of decentralized finance. Those that do, in turn, will be in a better position to innovate and offer new solutions that will enable DeFi to reach its true potential. With more than a hundred projects in the works, it is safe to assume that the DeFi sector will continue to grow and evolve over time.

Uniswap was the first true decentralized AMM to enter the market in November 2019. The “k” stands for the result of the multiplication – a number that must ALWAYS remain the same in this equation, no matter what. You agree to put 1000 forks into the special ship, while the residents of the other island agree to add 1000 spoons. The AMMs we know and use today like Uniswap, Curve, and PancakeSwap are elegant in design, but quite limited in features.

Meanwhile, market makers on order book exchanges can control exactly the price points at which they want to buy and sell tokens. This leads to very high capital efficiency, but with the trade-off of requiring active participation and oversight of liquidity provisioning. Impermanent loss is the difference in value over time between depositing tokens in an AMM versus simply holding those tokens in a wallet. This loss occurs when the market-wide price of tokens inside an AMM diverges in any direction. The profit extracted by arbitrageurs is siphoned from the pockets of liquidity providers, creating a loss.

This movement may be insignificant for pools with large liquidity or trades with low volume. But a large swap order for a token with a small market cap or liquidity can move the price significantly. This happens automatically via smart contracts which “mints” liquidity tokens and distributes them to the user as proof of his share of the pool. The number of tokens that are “minted” is proportional to the value of coins that users contribute to the pool. For every withdrawal, the user gets back his share of the pool and the liquidity token will be “burn”. My proposed solution is to use the style of “on-chain automated market maker” used in prediction markets in a decentralized exchange context.

With each trade, the price of the pooled ETH will gradually recover until it matches the standard market rate. Notably, only high-net-worth individuals or companies can assume the role of a liquidity provider in traditional exchanges. As for AMMs, any entity can become liquidity providers as long as it meets the requirements hardcoded into the smart contract.

AMMs are specific to newer decentralized exchanges (including Uniswap), utilizing complex mathematical operations (through smart contracts in most instances) to set the price of any given token. Traditional finance uses a demand and supply model to determine the price of any asset. When liquidity providers (LPs) deposit token pairs into liquidity pools, they generally deposit an equal ratio of each asset. As in the previous example, when providing liquidity to a Uniswap liquidity pool, LPs provide an equal ratio of two different assets. But, if you deposit one ETH worth $3,000 along with 3,000 USDC, there’s no guarantee that this ratio will be the same when you withdraw your liquidity.

Even though the technology is still relatively new and unknown to a lot of people, some are fascinated by how it is revolutionizing traditional finance. Who or what exactly are you giving your coins to, and getting new coins from? Well, the “special ship” in our example has an even more special fuel tank – it’s actually called a “liquidity pool”. Why is it so fast and easy to set up a market for the latest food coin?