Automated Market Maker (AMM) based Decentralized Exchanges (DEXs) have proven to be one of the most impactful DeFi innovations. They enable the creation and running of openly accessible on-chain liquidity for a range of different tokens.
AMMs fundamentally alter how users swap cryptocurrencies. Instead of using a traditional buy/sell order book, both sides of trades are pre-funded by on-chain liquidity pools. Liquidity pools allow users to seamlessly switch between tokens on-chain in a completely decentralized and non-custodial manner. Liquidity providers earn passive income via trading fees based on the percentage of their contribution to the pool.
In this article, we explore how AMMs work, dissect their inherent problems, and examine solutions to solve these key obstacles. Some of the key takeaways include:There are several AMM types: Constant Sum Market Maker (CSMM), Constant Mean Market Maker (CMMM), and advanced Hybrid CFMMs. Some of the key challenges that AMMs must overcome include impermanent loss, forced multi-token exposure, and low capital efficiency. Innovations by Bancor, Uniswap, Curve, and others are making AMMs more attractive to larger liquidity providers by improving capital efficiency, reducing volatility risk, and providing more capital deployment options. Using Chainlink oracles, Bancor aims to be the first to solve the problem of impermanent loss on volatile tokens in their upcoming V2 release.
By providing a more thorough analysis, we hope to better inform DeFi users about the challenges and innovations of AMMs, so that decentralized liquidity can realize its full potential as a fundamental building block for DeFi and the broader financial world.Overview of Automated Market Makers (AMMs)
Market makers (MMs) are entities tasked with creating price action on an exchange that would otherwise be illiquid without trading activity. This is done by MMs buying and selling assets from their o...