The world of cryptocurrencies is full of abbreviations; we have all seen FOMO, FUD, HODL, etc. Among the lesser-known and more technical ones is AMM, which stands for Automated Market Maker. Please allow us to break it down for you below.
Definition of AMM
An automated market maker, a financial tool typical for Ethereum and DeFi exclusively, is a smart contract that creates liquidity pools of ERC20 tokens.
One can attribute the popularity of AMMs to the fact that they have effectively replaced the traditional way of trading, namely via an order book, as they allow permissionless and automatic trading of digital assets using liquidity pools run by algorithms.
This new technology is everything blockchain stands for — decentralization, unparalleled uptime, permissionless environment, and open-source access.
Liquidity Pools and Liquidity Providers
Before AMMs, liquidity posed a troublesome challenge for decentralized exchanges on Ethereum, which back then were just an example of new technology with a sophisticated interface. AMMs swooped in and saved the day by creating liquidity pools and incentivizing liquidity providers.
Anyone who owns any ERC20 token and has access to the Internet can become a liquidity provider and supply an AMM liquidity pool with assets in exchange for a fee.
Constant Formula, the Secret Ingredient of AMMs
A simple mathematical formula is at the heart of AMMs. Ethereum founder Vitalik Buterin proposed the most common one, which later on Uniswap has popularized as x * y = k.
In this formula, k stands for constant, which, as the name suggests, means there is a consistent balance of assets that determines the price of tokens in a liquidity pool.
Let us look at a simplified example. An AMM has two volatile assets; every time someone buys the first asset, its price increases as the amount of the respective token in the pool is lower than before the purchase. Meanwhile, the price of the second asset decreases as there is more of it in the liquidity pool. As a result, the latter remains in constant balance, where the total value of both assets will always be equal regardless of how volatile prices get.
The constant formula is a unique component of AMMs, as it determines how the different AMMs function.
How Can AMMs Earn You Money?
Since the proper functioning of AMMs depends on liquidity provision, they create incentives (usually native tokens) to reward the respective providers.
By becoming participants in a liquidity pool, users can collect part of the profit from trading fees. The easiest way to be a liquidity provider is to supply a liquidity pool with two separate tokens (e.g., ETH and USDT), which ensures that swaps between these assets will be easier to execute.
To Which Category Does Finexify Belong?
In essence, Finexify acts as a liquidity provider for AMMs. Investors in our Ethereum Green Legend Fund contribute tokens to secure AMMs, scrutinized by our team. As a result, they receive part of the incentives that the Fund has earned.
As DeFi is still a nascent industry, bugs and rug pulls are not uncommon. That's why, it is crucial to know how to assess the smart contract risk when providing liquidity to Automated Market Maker (AMM) protocols. Find out what some the checks our team of experts performs before entering a new DeFi project.
About Finexify
Finexify is a boutique investment firm that provides one of a kind opportunity to get into and profit from the Decentralized Finance (DeFi) space – the most promising and complicated space of the blockchain industry.
The limited access to DeFi means extraordinary alpha with limited exposure to the cryptocurrency market volatility. Reserved only for the most crypto- and tech-savvy, the team of experts is more than prepared to exploit this profit opportunity for its investors.