Everything you need to know about DeFi markets
- DeFi market: AMM (Automated Market Makers a.k.a. DEXes)
DeFi (read Decentralized Finance) markets refers to a collection of decentralized digital marketplaces where DeFi services are exchanged, often incentivized using tokens as rewards (chicken-and-egg problem in crypto).
DeFi discards the idea of centralized financial intermediation.
What does that mean? By joining DeFi you’re not exactly disintermediating the middleman just yet, in fact, DeFi replaces it with a black-box smart contract which is supposed to abstract away all the back-end complex operations to spit out only what gets investors excited about.
Everything that required a trusted centralized party to guarantee the authentic and ethical execution of an instruction between customer and service provider is now replaced by code within a fair smart contract.
DEX trading, borrowing/lending, stablecoins, derivatives, fund management, insurance, payments and lottery. As the sector matures, these macrocategories within crypto will increasingly be treated as different asset classes for the purpose of diversification.
DeFi markets would not be complete without an easy way to exchange value for value (among fungible tokens – for now) through AMMs or Decentralized Exchanges.
Automated Market Makers( AMM)- The differentiator
An Automated Market Maker (AMM) is a smart contract that wraps pools of assets and facilitates trades permissionlessly for anyone.
An AMM is decentralized because:
- Anyone can decide to supply liquidity to improve the slippage on a market pair
- Anyone can trade provided that you have a wallet and sufficient network tokens to pay for gas
- It cannot be shut down
- All trades are recorded on the blockchain, thus giving everyone the necessary information to trade
AMMs are therefore not orderbook based but liquidity pool driven platforms.
One of the earliest projects in the spac
It’s a kind of decentralized exchange (DEX) in which the price of assets is determined by a mathematical formula (each AMM has a different formula which is why each AMM is different from the other) which also has a progressive revision to the age-old method where pricing algorithms decide the price of assets. AMM also replaces the traditional order book system that keeps track of all purchase and sell orders used to duplicate the price and quantity of crypto assets. The matching of buyer and seller orders takes up part of the traders’ valuable time and has several serious drawbacks, such as slippage and lag in price discovery.
How does an AMM work?
In every trading exchange, an Automated Market Maker functions similarly to order books. However, the user doesn’t require a counterparty on the opposite side to complete the transaction. Instead, smart contracts interact with you, automating the trade and creating a market for the user so he can save on the valuable time waiting for a counterparty. In AMM’s, the trading takes place directly between user wallets with no requirement for a buyer or seller, thus allowing digital assets to be traded in a permissionless and automatic way by using liquidity pools. AMM users supply liquidity pools with crypto tokens, whose prices are determined by a constant mathematical formula, thus enabling the transfer of an asset from the seller to a buyer at a fair price.
The variations in AMM models
While several AMM’s have come up with their unique formula, three dominant AMM models have emerged to prominence: Uniswap, Curve, and Balancer.
- Uniswap’s pioneering technology allows users to create a liquidity pool with any pair of ERC-20 tokens with a 50/50 ratio and has become the most enduring AMM model on Ethereum.
- Curve specializes in creating liquidity pools of similar assets such as stablecoins. As a result, it offers some of the lowest rates and most efficient trades in the industry while solving limited liquidity problems.
- Balancer stretches the limits of Uniswap by allowing users to create dynamic liquidity pools of up to eight different assets in any ratio, thus expanding AMMs’ flexibility.
Advantages of AMM
As we have seen how AMM radically changes some concepts of traditional centralized exchanges, there are several advantages to come with these changes. These are
- AMM has to the creation of a lot of New trading models
- Price slippage between the execution of trades reduces down dramatically to as low as a penny
- Orders are created in seconds and for a fraction of the cost.
- Latency on trade calls also diminishes drastically and can now be measured in milliseconds.
- The AMM help in developing high comparative liquidity thanks to its liquidity pools
- AMM’s reduce the ability and number of bad actors doing things like front-running, price manipulation, and wash trading.
- AMM’s reduce the price fluctuation to acceptable levels, which in turn leads to less slippage.
Disadvantages of AMM
Like everything coin has two sides, AMM’s too have disadvantages.
To list a few
- A disadvantage of this lack of oversight and lack of legal framework, which might be there as there are no governing authorities to monitor transactions, offer assistance, or provide a legal framework or redressals systems.
- As more financial transactions are conducted via decentralized markets, they can pose challenges for regulators and legal enforcement. In comparison, centralized markets give regulators a clear path for taking action, if necessary, regarding trades that might be suspect