How does an Automated Market Maker work?
An AMM operates based on the concept of liquidity provision, which involves depositing assets into a liquidity pool. The assets in the pool are used to back the prices of the assets traded on the Automated Market Maker. The AMM algorithm uses the amount of assets in the pool and the demand for each asset to determine its price.
When a user wants to trade an asset, they send a transaction to the Automated Market Maker’s smart contract, which automatically executes the trade based on the current prices set by the algorithm. The price of the assets can change dynamically as more users trade, affecting the ratio of assets in the liquidity pool and thus the price of the assets being traded.
What are the benefits of using an AMM?
- Decentralization: Automated Market Makers are decentralized, meaning that they are not controlled by any central authority or intermediaries. This makes them more secure and less prone to manipulation and censorship compared to centralized exchanges.
- Liquidity: AMMs use a liquidity pool to ensure that there is always sufficient liquidity to execute trades, making it easier to buy and sell assets even in illiquid markets.
- Accessibility: AMMs do not require users to go through a lengthy verification process or to deposit large sums of money to start trading. This makes it accessible to a wider range of users, including those in countries with strict capital controls.
- Lower fees: AMMs typically have lower fees compared to centralized exchanges, as they do not need to charge high fees to cover the costs of running the platform and maintaining order books.
What are the disadvantages of using an AMM?
- Price slippage: AMMs are subject to price slippage, which means that the price of an asset can change significantly from the time a user places an order to the time the order is executed.
- Lack of control: AMMs do not allow users to set the price at which they want to buy or sell an asset, as the prices are set automatically by the algorithm. This can be a disadvantage for users who want more control over their trades.
- Limited asset selection: Automated Market Makers typically have a limited selection of assets available for trading compared to centralized exchanges, as they require sufficient liquidity in the pool to ensure stable prices.