Automated Market-Makers: Understanding The Backbone of DeFi

Imagine a world where trading is as easy as picking a gem from a treasure chest.

Welcome to the realm of Automated Market-Makers (AMMs), the underlying protocol that powers all decentralized exchanges (DEXs).

Let’s dig in!

What is an Automated Market-Maker?

Automated Market-Makers are autonomous protocols that use smart contracts to define the price of digital assets and provide liquidity.

Users are not technically trading against counterparties — instead, they are trading against the liquidity locked inside smart contracts, often referred to as liquidity pools.

These autonomous trading mechanisms have revolutionized the crypto world by eliminating the need for centralized exchanges and traditional market-making techniques.

How do AMMs work?

The working of AMMs can be compared to the process of mining a gem. Just as a gem is formed under specific conditions, AMMs operate based on preset mathematical equations.

For instance, Uniswap and many other DeFi exchange protocols use a simple x*y=k equation to set the mathematical relationship between the particular assets held in the liquidity pools.

When large orders are placed in AMMs and a sizable amount of a token is removed or added to a pool, it can cause notable discrepancies to appear between the asset’s price in the pool and its market price.

This creates an arbitrage opportunity, much like finding a precious gem at a discounted price.

The Role of Liquidity Providers in AMMs

Just as miners extract precious gems, liquidity providers (LPs) play a crucial role in AMMs.

They deposit digital assets in liquidity pools so that other users can trade against these funds. As an incentive, the protocol rewards LPs with a fraction of the fees paid on transactions executed on the pool.

In addition to this, AMMs issue governance tokens to LPs as well as traders, granting them voting rights on issues relating to the governance and development of the AMM protocol.

Different Types of Automated Market Makers (AMMs)

Automated Market Makers (AMMs) are smart contracts that create a liquidity pool of tokens which are traded automatically.

The price of the tokens is determined by a mathematical formula based on the ratio of the tokens in the pool.

There are different types of AMMs, each with its unique characteristics and advantages:

1. Constant Product Market Makers: This is the most common type of AMM, used by platforms like Uniswap. They maintain a constant product of the quantities of two tokens in a pool. The main advantage of this model is its simplicity and the fact that it guarantees liquidity at any price level.

2. Constant Mean Market Makers: These AMMs, used by Balancer, generalize the constant product formula to more than two tokens. They allow liquidity providers to create pools with arbitrary weights, meaning they can set the ratio of tokens in the pool.

3. Stableswap Market Makers: These AMMs, used by Curve Finance, are designed for stablecoins. They provide low slippage trades for stablecoins that are pegged to the same value.

4. Hybrid Market Makers: These AMMs, like Bancor, combine order book models with AMM principles. They allow single-token liquidity provision, protecting liquidity providers from impermanent loss.

Virtual Automated Market Makers (vAMMs)

Virtual Automated Market Makers (vAMMs) are a new kind of AMM that expands its application from token swaps to perpetual contracts.

They work similarly to non-virtual AMMs, having a constant product curve (x*y=k), but the liquidity is virtual, meaning there is no exchange of assets

Also, the vAMM does not hold an asset pair’s two sides in custody. Notably, Perpetual Protocol first introduced the virtual automated market maker (vAMM) concept.

Properties of a vAMM

1. Non-requirement of liquidity providers: To bring liquidity for a vAMM to work, there is no requirement for the existence of liquidity providers. The traders offer liquidity to every order. Also, as there is no need for a liquidity provider in a vAMM, no impermanent loss exists.

2. Managing slippage: Similar to conventional AMMs, traders face less slippage for vAMMs when the value of K is greater. However, this similarity ends there. In contrast to AMMs, as the vAMM operator manually sets the value of K at launch, it is possible to voluntarily increase or decrease it at any time, even after the creation of vAMM. This helps the market respond to the most current conditions.

A vAMM is not used for spot trading but for price discovery in handling leverage. The vAMM calculates the exit or entry price each time one makes a trade.

This calculation takes place the same way as price calculation occurs on AMM-style exchanges.

The first-generation vAMMs made use of a fixed formula to calculate prices. But the second-generation vAMMs use a robust liquidity design and virtual tokens to enable makers to offer liquidity with leverage.

Difference from Virtual Automated Market Makers

The main difference between AMMs and vAMMs lies in the fact that vAMMs do not require liquidity providers.

This is because the liquidity in vAMMs is virtual, meaning there is no exchange of assets. Also, vAMMs do not hold an asset pair’s two sides in custody.

This makes vAMMs particularly suitable for handling leveraged trades, as they can calculate the entry or exit price for each trade. In contrast, AMMs require liquidity providers to function and are used for spot trading.

Conclusion

Automated Market Makers (AMMs) and Virtual Automated Market Makers (vAMMs) are revolutionizing the world of decentralized finance.

They are making it possible for anyone, anywhere, to participate in the global financial system, without the need for intermediaries.

Whether you're a trader looking for low slippage trades or a liquidity provider seeking to earn fees, AMMs and vAMMs offer a wealth of opportunities.

However, like any financial system, they come with their own set of risks and challenges.

Understanding these systems, how they work, and how to navigate them is crucial for anyone looking to participate in the DeFi space.

That's where Blockgem comes in. We're here to help you navigate the complex world of DeFi.

Our platform provides you with the tools and resources you need to understand and engage with DeFi protocols like AMMs and vAMMs.

Ready to dive into the world of AMMs and vAMMs? Start your journey with Blockgem today.

Visit Blockgem's Get Started page to learn more about how we can help you shine in the world of DeFi. Remember, in the world of DeFi, knowledge is the most precious gem. Let's mine it together with Blockgem!