AMMs facilitate the trading of digital assets, by eliminating the need for traditional order books and intermediaries. Instead, they rely on smart contracts.
Here's how it functions: When a user wants to trade one digital asset for another within an AMM-based decentralized exchange, they interact with a smart contract. This contract is responsible for maintaining a liquidity pool, which contains pairs of assets, e.g., Ethereum and DAI. Users can deposit their assets into these pools in exchange for pool tokens that represent their share of the pool's liquidity.
The bonding curve algorithm dynamically adjusts the price of assets within the pool based on the ratio of assets held. As one asset becomes scarcer (i.e., more users trade for it), its price increases according to the curve. Conversely, if users sell an asset, its price decreases. This ensures that the pool always maintains a balance between the two assets.
Traders can swap one asset for another by interacting with the smart contract, which automatically calculates the appropriate exchange rate based on the bonding curve's algorithm. As more users trade, the bonding curve adapts, allowing the market to find a new equilibrium price continuously.
Advantages & Applications
- Liquidity: They provide continuous liquidity for various digital assets, enabling trading at any time.
- Accessibility: AMMs are accessible to anyone with an internet connection, democratizing access to financial markets.
- Efficiency: The automated pricing mechanism and use of smart contracts reduces the need for intermediaries and allows for 24/7 trading.
- Token Launches: AMMs are used for initial token offerings (ICOs) and liquidity bootstrapping events, simplifying token distribution.
Limitations & Risks
- Impermanent Loss: Liquidity providers may experience losses due to price divergence between the assets in the pool and external market prices.
- Limited Price Discovery: AMMs may struggle with providing accurate price information for assets with low liquidity.
- Front-Running: Vulnerabilities in AMM smart contracts can be exploited by malicious actors to front-run or manipulate trades.
- Slippage: For larger trades, the price may deviate significantly from the expected rate due to the bonding curve.
Key Considerations
- Liquidity Management: Designers must consider strategies for attracting and retaining liquidity providers, as this is critical for the AMM's performance.
- Security: Ensuring the smart contracts are secure and free from vulnerabilities is paramount to prevent exploitation.
- Slippage Tolerance: AMM parameters must be set to accommodate users' tolerance for price slippage.
- Pair Selection: Choosing the right asset pairs to create liquidity pools is essential for effective operation.
- Bonding Curve: Depending on the intended use of the liquidity pools in the exchange, developers must decide which pricing function they want to implement. Today, most AMMs are some form of Constant Function Market Maker such as Constant Sum, Constant Product, Constant Mean, or some combination of these. Each will result to different levels of liquidity, price impact, and slippage. See here for more information.
- Number of Assets in Pools: Designers must consider how many assets each liquidity pool can have, as well as the price volatility of these assets. This will have implications on the curve function to be chosen. Some AMMs exclusively allow for dual-asset pools (Uniswap, Curve), while others allow for multi-asset pools (Balancer).
This entry was coauthored by Alex Weseley.