We will continue our defi tutorial by exploring the fundamentals of one of the most important applications in the ecosystem: automated market makers (AMM).
AMMs enable unstoppable, automatic, and decentralized trading without the need for buyers, sellers, or a central reserve. Instead, they crowdsource liquidity and execute trades via smart contracts. AMMs are currently the backbone of the entire decentralized exchange ecosystem and have significantly improved its capabilities since Vitalik Buterin first proposed them in 2017.
The reason why defi market making has become so popular is because it eliminates a major source of friction in the decentralized finance world. In traditional financial markets, market makers make money by matching buy and sell orders for a given asset pair and thereby reducing the spread between bid and ask prices. However, achieving this requires sophisticated predictive ability which isn’t available to unsophisticated parties.
In DeFi, AMMs solve this problem by creating a pool of crypto assets and facilitating trades between those assets. The assets are traded by non-custodial, permissionless smart contracts that run on the blockchain. This enables the creation of DEXs that are both completely decentralized and highly liquid.
Most DeFis offer two types of pooled assets: constant function market makers and flexible liquidity pools. Both categories utilize non-custodial smart contracts and a deterministic pricing rule. They can be implemented individually or in combination, and they can use different ratios to optimize for specific purposes.
Both of these methods can reduce the impermanent loss of an individual token, and they are thus the most important tools in the DeFi market maker’s arsenal. In addition, both of these methods allow the creation of liquidity pools with a wide variety of coin and token pairs, thus increasing the chances of a successful match between the demand and supply of a given asset.
This is why Uniswap, Sushiswap, Balancer, and many other defi projects are able to regularly surpass the trading volume of major centralized exchanges like Coinbase Pro and Kraken. However, it is worth pointing out that most of the volume on these defi exchanges comes from passive liquidity that doesn’t leverage advanced predictive ability. This is why we’ll dedicate a future lesson to both liquidity mining and yield farming, which are ways for market participants to earn passive income by providing liquidity. We will also discuss the pros and cons of each approach and see which one is best for different situations. This will give us a clearer picture of the actual economics behind DeFi market making. If you’re interested in learning more, feel free to check out our previous lessons on the defi ecosystem.