The world of financial trading is a complex system that involves many different parts and everyone who wants to succeed in this field should know as much as possible. This goes even further for cryptocurrencies, as blockchain is a complex system and there are so many possibilities for new innovations. Since the crypto financial market is split into two major parts, centralized and decentralized, there are some small, but important, differences to take note of.
In the case of decentralized exchanges, the possibility of innovation and freedom is more, since they are not tied down by regulatory bodies. Among these decentralized exchanges, DEX for short, automated market makers are one of the integral parts that make most of these decentralized exchanges work smoothly. But what are these automated market makers and why are they important?
What is an automated market maker?
An automated market maker (AMM) is an integral part of decentralized exchanges and removes the need for order books. AMM is a protocol that uses mathematical formulas to calculate the price of an asset, and it does not rely on the order book and person-to-person order transactions in order to complete market orders. What this means is that, for example, when you want to sell Bitcoin for USDT and place an order, regular exchanges look through order books to find someone who wants to exchange Bitcoin for USDT, then the system pairs up these people and executes both trades.
In the case of automated market makers, this is removed and everything is done through protocols rather than an order book. Each decentralized exchange will have some sort of formula for these calculations and there is no universal formula that is being used by everyone. But in most cases, these formulas are built based on liquidity pools and prices are calculated by how many tokens are in these liquidity pools, and differences appear in the way they are calculated.
These liquidity pools are what make it possible for these decentralized exchanges and automated market makers to work. Each trading pair will have its own liquidity pool, so for example, when trading with BTC/USDT on a decentralized exchange, there is a dedicated liquidity pool where a certain amount of BTC and USDT is deposited, and when trading, the funds from these liquidity pools are used for completing orders.
Benefits of an automated market maker
Automated market makers bring a lot of benefits to traders who use decentralized exchanges. When trading with cryptocurrencies that rely on order books, you are dependent on someone else. What we mean by this is that, if there is no order from someone who wants to buy the crypto you are selling for the price you want, your order won’t be executed. While for very big exchanges this is not a problem, especially for popular trading pairs, when it comes to trading with lesser-known pairs, the possibility of an order not being executed is relatively high, since not many people are trading with them. But thanks to automated market makers, it does not matter how popular the pair is, if there is an option to trade with this pair, your order will always be executed.
Automated market makers also bring additional opportunities for making extra money. Anyone can visit decentralized exchanges, choose a trading pair they want to contribute towards, and deposit some funds into these pools. These funds are then used for these automated market makers and liquidity providers are rewarded with the percentage of trading fees generated from these trading pairs. What this means is that anyone who owns some cryptocurrencies can visit decentralized exchanges, provide liquidity for automated market makers and earn rewards for doing so. Some decentralized exchanges even reward these liquidity providers with the native cryptocurrency of the exchange.
FAQs on automated market makers
What is the benefit of an AMM?
The main benefit of the automated market maker is that it provides stability to the exchange. Since automated market makers don’t rely on order books, there is no need to have two separate parties on both sides of the trade, and trades can be executed peer-to-contract. What this means is that, wherever you see a trading pair on a decentralized exchange that uses AMM, you will be able to trade with this currency instantaneously and are not dependent on someone else wanting to execute the opposite side of your order.
What is AMM liquidity mining?
Automated market maker liquidity mining is the process of providing liquidity to decentralized exchanges, for which you receive rewards. When providing liquidity to an AMM, you will need to choose the trading pair you are providing liquidity for, then deposit either one or both cryptocurrencies, depending on the exchange you are using, and then simply sit back and enjoy the rewards. Each time orders are executed from the pool you provided liquidity for you are earning rewards in the form of trading fees or other cryptocurrencies.