November 4, 2020

What is AMM? Explaining the Automated Market Maker Protocol

Anton Golub, the CEO and Co-Founder of Flovtec shares details about the AMM protocols. Automated Market Maker protocols are smart contracts which automatically offers a price for the exchange of the digital assets. The Automated Market Maker Protocols come with a few features. First is, the AMM protocols offer a single price for the exchange of two digital assets instead of a full order book. Also, the price that the AMM protocols offer are very popular. Thirdly, they don’t have capital themselves and they gather capitals from the third-party participants through the liquidity pools and the way the participants get incentives to offer capital to the liquidity pools is because the AMM protocols share a certain part of the trade fee along with the capital providers.

[Transcription of Video]

Hello everyone,

Today we are going to talk about automated market making protocols. In the last video we explained what is decentralized finance (DeFi). Decentralized finance is a movement to transform financial services we use everyday like savings, investing, or hedging into open, safe and secure protocols that function without any intermediaries. And the key ingredient of decentralized finance are smart contracts which are programs that automatically execute a task or a process when certain conditions are met.

Now before we explain automated market making protocols let’s explain what is market making. Now the key term here is actually liquidity. Liquidity is a very important feature of any financial asset and it describes the ability to buy or sell an asset without drastically changing price. Now the reason why liquidity is so important for assets is because liquid assets are less risky and more attractive for the end investors. A market maker is a company that quotes those buy and sell prices and making a digital asset liquid. And to mention, the market makers use either their own capital or capital from other investors to provide liquidity.

Now we are ready to explain what market making protocols are. Automated market making protocols are actually smart contracts that automatically provide a price to exchange to digital assets. Now, automated market making protocols have a couple of peculiar features. For instance, the first one is that the automate market making protocols usually provide a single price for an exchange of two digital assets and not full orderbook.

Secondly, the price that the automated market making protocols provide is usually well-known and deterministic. And the third particular feature of automated market making protocols is that they don’t have capitals themselves and they have to gather it from third-party participants through so-called liquidity pools. And the way the participants are incentivized to provide capitals to those liquidity pools is because the automated market making protocols share a part of the trading fee with the capital providers.

And lastly but not least important, automated market making protocols suffer from the same latency that the centralized networks have which are still quite small.

Now, automated market making protocols might seem to be very innovative and new but it turns out we have had similar attempts in the past in traditional financial markets where people used similar methods to exchange assets. In the early 90s the US equity markets implemented the small order execution system that mandated market makers to quote prices at predetermined levels for certain stocks. Now, unfortunately the small order execution system was not a success story because participants easily arbitraged market makers that participated in these particular programs. And those participants who made those arbitrage were actually called the SOES bandits.

Automated market making protocols such as Uniswap has gained a lot of traction in the last months and it has been a very positive development for a lot of small projects who wanted to gain traction and exposure without having to be listed on a large digital asset exchange. Unfortunately, the participants in the market making protocols still have a lot of risk if they don’t understand they are being arbitraged.

We at flovtec, actually welcome the positive developments of the automated market making protocols and we think they definitely have their place in the future but in the short term they will not replace professional digital asset exchanges with centralized order books.

I hope you enjoyed the video and thank you for watching.

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