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What Is an Automated Market Maker (AMM)?

UTC by Beatrice Mastropietro · 7 min read
What Is an Automated Market Maker (AMM)?
Photo: Depositphotos

An automated market maker (AMM) is computer software that operates a trading platform to make orders based on real-time data and market conditions. An AMM provides liquidity for many financial instruments. In this guide, there is all you need to know about AMM.

The US Securities and Exchange Commission (SEC) has defined an automated trading system as a computer program that generates or routes orders to a market center, generally without any human intervention. The primary purpose of an Automated Market Maker is to provide continuous order flow in all market environments by providing two-sided quotes at the best available prices so that investors can trade almost 24/7.

Market Making

Market making is a new concept, and it remains somewhat controversial as to whether or not market makers provide an effective service. It essentially involves creating trading activity without the intention of taking either side of the trade. Market makers get a fixed fee per share traded and by giving their clients tight bid/ask spreads.

With market makers on both sides of the trade, traders no longer need to be concerned with market direction when initiating trades, meaning that market makers reduce transaction costs for the individual trader. Additionally, if there were no market makers, then traders would have to keep “quotes” since there would be no one.

Market makers are vital to any given financial market. They provide liquidity by quoting both bids and asks at all times while also maintaining the essential price continuity that allows traders and investors to have confidence with prices quoted.

What is an Automated Market Maker?

An Automated Market Maker (AMM) is a trading system designed to provide liquidity in stocks, options, and futures markets without having to possess the security or deliver the commodity. It is an electronic trading system where an owner offers to buy and sell stocks at quoted prices with little or no price changes. The AMM’s computer continuously monitors stock prices on a number of exchanges and determines what a fair bid/asked price for each equity security. This information is posted on a visible quotation board which traders can access via the internet.

AMM’s Functioning

Automated Market Maker (AMM) is the latest automated trading product introduced by CMC Markets. AMM provides traders with a fully automatic trading tool to make a profit without human emotion or error. The technology behind AMM runs on the foundation of algorithmic trading.

AMM provides manual and automated signals in one set up making it easy for traders to start profiting from their initial trading investment. Traders can choose either to follow an automated signal, which will begin trading instantly, or they can go into manual mode and take over control at any time if they wish. This function gives traders more power allowing them to react quicker.

Liquidity Pools and Liquidity Providers

Liquidity Pools are the foundational building blocks of Decentralized Exchanges. They serve to connect traders with liquidity providers who have the opposite trading interests. Liquidity pools allow all traders, even those with small capital, to trade on DEXs without losing out or taking undue risks. The current iteration of ZeroEx’s decentralized exchange focuses on liquidity pools (or market maker groups), where individual members pool their funds together into these groups and act as market makers for every token a given group offers.

A DEX is an automated market maker. In a human-based approach, a trader will visit and exchange, create buy and sell orders and wait for filling and clearing order before withdrawing their funds from the exchange. In contrast, there are no human involvement in filling your buy order with AMMs. Instead, algorithms fill your order against other users’ orders based on price/time priority. That means when you place a buy or sell order, you are letting the algorithm decide whether it’s beneficial for them to match your order with other users’ orders they might have that they can profitably fill on top of yours.

Most Popular AMM Platforms

Let us look at the most popular Automated Market Maker platforms.

Uniswap

The AMM concept has been gaining momentum over the past year and now offers many platforms to choose from. Some AMM platforms have designed their systems with specific user needs in mind. Traders built Uniswap (UNI) for traders, making it one of the most popular AMM Platforms on the internet today. Indeed, markets are not identical and there is no one size fits all solution. Meanwhile, Uniswap can serve as an AMM platform or as your main trading interface with any exchange you like.

Kyber Network

Kyber Network (KNC) is a decentralized, trustless exchange that runs on the Ethereum (ETH) Blockchain. AMM works as an intermediary between two parties seeking to trade an asset through Kyber. For example, Alice wants to trade her 10 KNC for Bob’s AMM, which has X AMMC3 in AMMC3 supply. AMM platforms work autonomously, and participants only need to submit their transaction requests with their desired parameters such as Buy/Sell AMMC3 at what price or orders of magnitude. Kyber monitors the entire AMM market using Smart Contracts to garner data regarding AMMC3 liquidity.

Benefits of Using AMMs

Any time you trade on an exchange, central market-makers are facilitating your transaction. The AMM stands behind the quote that is listed for a trader to place an order against. As long as his price is better than what AMM can do for themselves directly, they will be executed against each other and AMM will make a profit at some point. AMMs provide essential services in modern markets. In particular, they improve execution speed, provide liquidity, ensure fairness in pricing and trading practices by keeping spreads narrow. They also reduce costs associated with using liquidity pools or human traders who need salaries paid every month. AMMs lower the volatility of prices by collecting information from the best sources available (other AMMs) and averaging them.

Downsides of AMMs

Automated Market Makers have several disadvantages that make them undesirable from an investor’s point of view. AMMs maintain the best bid and offer for a stock. But often your AMM will not be able to determine the correct bid or ask price. As a result, AMMs can lead to significant losses and affect market efficiency. AMMs do not necessarily add liquidity to the marketplace, meaning they may only act on one side of the trade as AMMs usually deal in large blocks of shares. AMM does this by searching for the highest bid or lowest ask prices available at any given moment rather than trying to get you into a better position. Besides, AMMs are sometimes referred to as predatory traders because they buy out all of the other available shares.

AMMs’ prices are not transparent, making their impact on the market impossible to assess and monitor. Many AMM algorithms involve many highly sophisticated mathematical formulaы that are too complex for human intervention or oversight. AMMs often provide liquidity to illiquid stocks. However, AMMs may cause flash crashes that regulators can not turn off in times of crisis. While AMM orders can reduce spreads and increase liquidity, AMM volume ratios have been increasing over the years. AMMs want more money per trade without providing sufficiently better service, leaving other traders worse off. Some critics believe that AMM activity is distorting stock price levels so much.

Conclusion

Automated market makers are an integral part of the DeFi space. While they have some limitations, their ability to be put in place is invaluable.

AMMs, the automated version of market makers, are still in their infancy. They offer elegant design and features. But they face limitations that future releases can overcome, such as lower fees, less friction for investments, and inducing marketing strategies.

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FAQ

What is an Automated Market Maker?

An automated market maker (AMM) is computer software that operates a trading platform to make orders based on real-time data and market conditions.

How does an AMM work?

The AMM is an algorithm that automatically uses the liquidity pools on different cryptocurrency exchanges to complete trades without needing another trader.

What are liquidity pools and liquidity providers?

Liquidity providers provide liquidity to securities markets and liquidity pools are the entities they negotiate liquidity agreements with.

Why use AMMs?

AMMs help to address liquidity issues in exchange by creating liquidity pools and offering incentives to providers. 

What is impermanent loss?

Impermanent loss occurs when an algorithmically driven token rebalancing program alters the price of tokens from one side of a pool to the other.

What are the prime examples of AMM platforms?

The most popular and common choices are Uniswap, Curve, Kyber Network, and Balancer.

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