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Automated Market Makers (AMMs) & Their Role in DeFi

April 12, 2023

DeFi has been struggling with liquidity for a long time. As decentralized exchanges (DEXes) aim to eliminate any involvement of third parties in crypto trading, giving users more independence and complete decentralization, they inevitably lose liquidity currently concentrated on centralized exchanges (CEXes). 

Like with traditional assets, cryptocurrency liquidity refers to the ease with which you can exchange your crypto asset for fiat currency or another asset. Sufficient or high liquidity means the market is stable and that price fluctuations are minimal. Low liquidity, conversely, results in market volatility, frequent price spikes, and significant delays in exchange. Therefore, DEXes are working hard to increase their liquidity levels to provide users with a seamless exchange of assets between various networks. One solution is an automated market maker (AMM).

What are AMMs and Liquidity Pools? 

AMM is a solution unique to Ethereum and EVM-compatible networks. This method of exchanging assets aligns with the core principles and values of Ethereum and cryptocurrency in general, prioritizing decentralization and accessibility for all users who wish to participate and innovate.

An AMM is an autonomous protocol that automates the process of matching orders and replaces traditional order books. With AMMs, users can exchange assets twenty-four hours a day by trading against liquidity pools, which are crowdsourced pools of coins and tokens locked in smart contracts. These pools help maintain adequate levels of liquidity and facilitate speedy transactions, making DEXes more robust and efficient. 

However, such an approach also means that DEXes highly depend on users to provide crypto assets in pools. That is why DEXes often need to create incentives that encourage users to supply their tokens to specific pools. Various incentives help to ensure adequate liquidity even for the rarest crypto assets. 

In order to determine prices in liquidity pools, DEXes use mathematical formulas, which can vary from one exchange to another. By adjusting these formulas, liquidity pools can be optimized for different purposes, enabling DeFi projects to achieve their specific goals.

Advantages & Disadvantages of AMMs

As mentioned above, AMMs could help stabilize exchange rates and improve the overall transparency of the exchange process on DEXes. There are two main benefits of Automated Market Makers (AMMs): stability and transparency. Firstly, they offer more stable liquidity as buyers and sellers exchange assets with a liquidity pool instead of depending on other traders. Secondly, AMMs provide transparency to the trading process by allowing traders to retain custody of their assets during trading.

However, while AMMs may be more beneficial for DEXes than order books, they are not a perfect solution. Although Automated Market Makers (AMMs) are expected to provide more stable liquidity, the reality is that many DEXes struggle to attract enough liquidity providers to maintain reasonable prices. It leads to serious issues such as high slippage risks, inability to guarantee the execution price, and a lack of protection against MEV attacks, all of which make trading on DEXes quite unpredictable and thus less attractive for users. Furthermore, using AMMs for cross-chain swaps can be expensive due to the high gas fees associated with network bridges.

Final Thoughts

The complex interface of DEXes has scared away many users initially, making it difficult to attract enough people willing to swap on DEXes regularly and maintain their stable work. AMMs with liquidity pools have helped DeFi projects address this issue by allowing users to become liquidity providers themselves. However, it has not resolved the problem entirely and has even created new issues. Therefore, the DeFi industry has to continue looking for new solutions to ensure an efficient and consistent way to exchange assets in a decentralized manner. 

Kinetex offers users a seamless swapping experience by aggregating over 200 liquidity sources, including DEXes and bridges. This way, Kinetex can achieve almost infinite liquidity, even for more rare tokens. 

Kinetex Network: Website | Kinetex dApp