AUTOMATED MARKET MAKER

AUTOMATED MARKET MAKER

From the word market maker, it means an individual firm, brokerage house or pub that provides liquidity to the market. They buy assets like stocks in bulk and sell in small portions to keep the financial market liquid. They profit from the difference in the bid-ask price (the price they want to sell minus the selling price of the stock). When technology and computer programs replace brokerage houses, it becomes an automated system.

An Automated Market Maker is a computer program integrated as part of decentralized exchanges and used to facilitate dealer and liquidity pool transaction systems instead of buyer and seller transaction systems. It removes intermediaries like the brokerage houses. Crypto is traded without a third party using liquidity pools. On traditional exchange platforms, buyers negotiate the price of an asset, such as stocks, gold, or real estate, with sellers until an acceptable price is struck. However, AMMs have a completely opposite approach. Instead of buyers relating to sellers, sellers now trade against a pool of tokens, buyers also trade the liquidity pools managed by smart contracts. So it's a peer-to-peer network. If a buyer wants a token, they don't need to negotiate with a seller, they go straight to the liquidity pool to exchange their token.

WHAT IS LIQUIDITY?

Liquidity is like going to the bank and finding numerous bank teller to take care of customers. This improves the flow of transactions and customers leave the bank enthusiastically and can even recommend the bank because of the perfect customer service. But it becomes illiquid when there's only one bank teller with a long line of customers - it's frustrating. Customers regret coming to the bank in the first place, just because transactions were slower than anticipated.

WHAT ARE LIQUIDITY POOLS?

Liquidity pools are an indispensable part of the decentralized financial system. They are used to support permissionless trading, lending, borrowing and many more functions. Pool means a place where funds, cryptocurrency tokens or digital assets of any kind are stored and locked and then managed by Smart Contracts. Liquidity pools have helped convert crypto into cash or fiat quickly without drastically changing the price of crypto or causing blips (the difference between the price you want to sell your crypto and the price it is actually sold) . Liquidity pools come in pairs.

For example, a user wants to exchange token A for token B on a decentralized exchange. So the user selects A as the token they own and again selects token B as the token they want to receive in exchange for token A. He deposits token A (any amount of his choice) to receive amount of token B in exchange. The amount of token B they can only get is determined by smart contract. In order for the user to get token B, the pool must have more than a sufficient amount of token B to give away not just for one user, but for different users wanting to trade at the same time. The sufficient amount of tokens is called liquidity.

Just as air is mandatory for humans in terms of survival, so is liquidity for any decentralized exchange.

WHO ARE LIQUIDITY PROVIDERS?

Users escrowing their tokens (these tokens are locked away and managed by a smart contract) are referred to as liquidity providers. The more tokens provided in a pool by liquidity providers, the more liquidity the pool has and the faster trading on decentralized exchanges becomes. This can only be possible if automated market makers motivate or encourage users to place their tokens in pools. Liquidity providers often receive a fee for depositing tokens in the pool. This fee is paid either by traders who interact with the liquidity pool or through the concept of yield farming (liquidity mining). Users received rewards for depositing their tokens in the liquidity pool. More users are depositing their tokens in the liquidity pools, more liquidity in the pool and faster transactions.

This is similar to depositing money into a savings account at a bank and collecting interest on the money deposited.

Anyone with an internet connection and holding any type of ERC-20 token can become a liquidity provider simply by depositing tokens into an AMM's liquidity pool.