A couple years ago Ethereum Foundation gave their first grant to an unknown developer, working on a crypto exchange service. That grant eventually became the first project to successfully launch an AMM based cryptocurrency platform - Uniswap 🦄
AMM changed the whole concept of exchanging coins and introduced what we now call liquidity pools. But let’s not rush too much and start from scratch.
What is AMM?
A protocol, that provides liquidity to an exchange automatically, trading assets permissionless 💱
How does it work?
For better understanding of the algorithm itself we will have to explore the reasoning behind its development and implementation first.
A minute of history
The first DEX exchanges ran on Ethereum and used the standard order book just like all the other centralized exchanges. For such a trading mechanism to be effective, whilst also remaining decentralized, transaction processing speed must be insane. Considering that transactions on a decentralized exchange are confirmed through the blockchain, the real speed and capabilities of such DEXs were extremely limited. AMM was the solution that took a fundamentally different approach, acting as a formula or a directory for who and how can trade assets 📔
The main and only source of asset liquidity in AMM are liquidity pools - collections of digital assets locked inside in smart contracts for further use.
There are always 2+ assets in the pools of international organizations. For example, Uniswap exchange, uses pools for paired tokens. The Balancer platform allows you to create pools for three or more tokens. The Curve protocol is used for pools based on similarly valued assets, such as ETH and WETH , or USDC and DAI. The operation of all these pools is regulated by the AMM.
For locking liquidity a user requires LP tokens which act as a kind of debenture, ensuring that the tokens are safe and can be withdrawn afterwards. The liquidity providers profit from fees, varying from 0.1% to 0.3% on most exchanges 👏
What are the cons?
The main and most significant disadvantage is how limited the transactions are in terms of their type. No stop loss orders can be placed on any exchanges. 1inch is the only exception that offers us a decentralized exchange with the latter, but the net is still too young to be considered reliable.
A simple conclusion
AMMs were the key to creating fast and secure exchanges with minimal requirements. The technology is still being developed, so the stop loss question will get solved sooner or later.
Stay tuned 📻