Throughout 2020 and for the better part of 2021, the decentralized finance (Defi) boom was pretty much fueled by an explosive uptake of automated market-making (AMM) protocols.
AMM platforms such as Uniswap and SushiSwap were going head to head in a war for liquidity. At the same time, tales of some crypto traders quadrupling their token holdings in a short period made rounds on social media.
Decentralized exchanges (DEXs) have come a long way from the days of order-book-based DEXs such as Ether Delta. The now revamped DEX space features many platforms such as QuickSwap and Bancor, to mention a few.
One thing is for sure, the advent of automated market-making protocols is the most noteworthy innovation in DeFi. According to Sergej Kunz, CEO of an AMM DEX called 1inch Network, “in the next four to five years, the DeFi industry will grow a lot.”
“We will eliminate intermediaries such as banks and replace them with DeFi in the upcoming years,” he says.
Indeed, DEXs built with AMM protocols are known for maintaining stable liquidity levels and enabling price discovery in a range of different token pairs without any intermediaries.
A primer on AMM protocols
First of all, without the work done by market makers to create price actions, any exchange, centralized or decentralized, would be rendered illiquid.
On centralized exchanges, market makers are incentivized by lower fees. However, AMM protocols are programmed with an inbuilt incentive for making markets on decentralized exchanges. Thus facilitating automatic price discovery without an intermediary.
How is this achieved? Well, AMMs come with smart contracts that use predefined rules to guide the process of setting prices on their own when market conditions require it.
By doing this, AMMs eliminate the need for human traders to make markets, as is the case on centralized order book-based exchanges.
Liquidity is key
However, price discovery is not the only problem that exchanges need to solve. Liquidity is also a key pillar. For this, AMMs work with smart contract-enabled liquidity pools.
These liquidity pools crowdsource capital from platform users. They lock those funds in a smart contract while distributing rewards to those who provide liquidity.
In a nutshell, instead of an order book and a matching engine, AMM-based DEXs use liquidity pools where users who want to become liquidity providers submit their tokens to a smart contract. Traders looking to swap one token for another can do that against the liquidity in the smart contract.
AMM protocols take the whole idea of a decentralized non-custodial exchange to a whole new level. For example, platforms such as Uniswap are democratizing liquidity provision like never before.
These smart contract-enabled programs’ design includes sophisticated mathematical formulas that enable automated price discovery and liquidity on a DEX.
The entire operation is completely decentralized and seamless such that prices are set automatically based on the algorithm that runs in the smart contract.
For instance, Uniswap uses a constant product formula that sets the price of assets in the liquidity pool based on supply and demand.
Other examples include Bancor, the first DEX to completely remove order books introducing a network of on-chain liquidity pools. Instead of setting prices based on supply and demand, Bancor’s AMM uses an algorithm that determines prices by assessing the size of the trade placed by the user and the depth of the corresponding liquidity pool.
Here are some examples of different AMM protocols. We’ll examine how they solve the problem of automated liquidity provision on the blockchain.
QuickSwap is a new contender in the DEX world. Although it features a similar AMM algorithm as Uniswap, QuickSwap features some subtle but important differences. Specifically, it is built on the layer-2 infrastructure of the Polygon Network.
Polygon is a protocol and a framework for building and connecting Ethereum-compatible blockchain networks. QuickSwap is the first AMM protocol on the Polygon infrastructure.
Thanks to its use of layer-2 for transaction settlement, QuickSwap supports the trading of thousands of ERC-20 tokens at near-zero gas costs and at super-fast speeds.
Unlike most AMM-based DEXs with anonymous developer teams and funny food names, QuickSwap was developed by experienced developers whose main agenda was to create a scalable next-generation DEX that will bring growth to the DeFi landscape.
QuickSwap also features a native token (QUICK) used for acquiring a governance position on the DEX. They just released limit orders and the “Dragon’s Syrup” program.
This allows $QUICK stakers to earn extra rewards by staking their $dQUICK, QUICK’s staked representative, to earn tokens traded on the DEX.
Even before DeFi was a thing, Bancor had already developed the first-ever automated market maker on a blockchain.
Israeli siblings Guy and Galia Benartzi founded the Bancor Network in 2018. It is best known for its amazing ICO run that gathered over $150 million in Ethereum tokens in around 3 hours.
The AMM protocol of Bancor is a complex algorithm. It uses many different parameters to calculate the current price for an asset in its liquidity pool.
First, it considers the size of the trade placed by the user and adjusts prices based on volume within each corresponding liquidity pool. The AMM also considers the durations between a trader’s active trades.
The AMM then uses the depth of liquidity within each pool to determine prices. Deeper pools have a higher weighting than shallower ones.
In addition, Bancor’s AMMs also considers active bids and asks placed by other traders on Bancor’s order book. These can be an additional price discovery mechanism.
Bancor Exchange also features an improved version of its DEX called v2.1 that operates through a novel mechanism called Single-Sided Liquidity.
This mechanism allows a liquidity provider to submit tokens to the liquidity pool while maintaining exposure to the token. This protects the trader from incidences that cause impermanent loss.
While Bancor Network was a pioneer of the AMM model, Uniswap boasts the title of being the first AMM-based DeFi platform to popularize the AMM model.
Uniswap brought about significant levels of liquidity and traction to the Ethereum blockchain. Ultimately, overloading the network leading up to skyrocketing gas fees.
Hayden Adams founded the platform. It launched in late 2018 after receiving funding from prominent venture capital firms such as Andreessen Horowitz.
According to Adams, Uniswap’s architecture was based on a theoretical on-chain decentralized exchange as described by Ethereum’s founder Vitalik Buterin in a Reddit post.
From that time, Uniswap has grown tremendously. So far managing to reach more than $9 billion in weekly trading volume, according to reports.
The Uniswap AMM protocol delivers immediate and automated liquidity without relying on any central entity. The smart contracts that enable the exchange are on-chain. As a result, users who interact with those smart contracts can do so in a completely non-custodial manner.
Therefore, users can still use the platform without undergoing KYC and AML requirements, signing any deposits or custodial agreements with an intermediary. These are all required by centralized exchanges.
Uniswap uses an AMM designed with constant product formula that determines the price of assets in its liquidity pools based on supply and demand.
While this approach has proven useful, it features inherent risks. These include impermanent loss and always on quotes that are vulnerable to network congestion and skyrocketing gas fees.
The future of AMM DEXs
AMM protocols are a promising technology for establishing a new paradigm in crypto asset trading. Their potential to offer on-chain liquidity can completely transform the current Defi landscape in unimaginable ways.
AMM DEXs bring a higher level of protection against hacks. In addition, they also provide a cheap and reliable way of trading crypto assets.
AMM protocols like QuickSwap, Uniswap, and Bancor Network are paving the way for the future of decentralized exchanges.
By democratizing liquidity provision and automating market making with algorithms on a smart contract, these protocols have the potential to make decentralized exchanges overtake centralized exchanges in terms of the trading volume.
Already, Uniswap is showing promise, having overtaken the trading volume of centralized exchanges such as Coinbase several times.
However, DEXs are not yet perfect. Most AMM protocols are riddled with the challenge of impermanent loss and skyrocketing fees whenever there is network congestion.
Granted, AMM protocols such as Quickswap are moving closer to solving existing challenges. However, only time will tell whether QuickSwap’s layer-2 solutions will be a silver bullet that enables completely automated non-custodial trading throughout the DeFi landscape.
Overall, AMMs have the potential to make or break decentralized exchanges. This is because they democratize liquidity provision and automatically provide market-making services in a tamper-proof way. This perhaps is the beginning of a new era of crypto-asset trading.