In this article, we will briefly explain what Automated Market Makers are and their importance in the DeFi space.
We will also talk about what DeFi is, what transactions in this sector entail, the most popular AMMs, and how to use such a protocol.
What is DeFi, in short? What is its purpose?
Decentralized Finance, or DeFi in short, is a financial ecosystem based on Blockchain technology.
Its purpose is to provide anyone with open-source, transparent financial services that, above all, work and operate without being managed by a central authority, unlike the classic financial system, in which banks represent that authority.
How do transactions work securely in DeFi?
Any data or value transfer in the DeFi area is based on Smart Contracts.
If in the classical system, the agreements between various entities are materialized by contracts and mutual consent, in DeFi, the consensus between the contracting parties is established and respected based on protocols that are pre-established by computerized code.
The advantage is that, since they are fully processed by a computer, Smart Contracts ensure a higher speed of execution, and the risks of human error are reduced.
At the same time, the disadvantage would be that a line of code may include bugs or that the information integrated here could be accessed and/or hijacked.
What are Automated Market Makers? What role do they play in the DeFi space?
Automated Market Makers are a class of decentralized exchanges that rely on an algorithm to determine the price of a digital asset and work with pairs of exchangeable assets.
These protocols are actually based on Smart Contracts that automatically set and offer an exchange price between two digital assets.
These assets will thus be automatically exchanged between them, based on an algorithm, and not an order book, as is the case with traditional finances.
Therefore, the entities participating in that exchange interact only with that Smart Contract and not with each other.
What are some of the characteristics of AMMs?
The first important feature of an AMM would be that, as a rule, it sets a single price for the exchange between 2 digital assets.
Secondly, the price thus set is known and therefore consistently visible to all exchange participants.
The third characteristic is that AMMs do not hold equity to facilitate trades but must store it from third parties, considered to be participating in this consensus.
The capital thus received is stored in what we call liquidity pools, and those who contribute to maintaining these pools receive a percentage of the trading fees charged by an AMM.
What are the most popular Automated Market Makers?
It is the most popular AMM, being built on the Ethereum blockchain in 2018. Thus, this decentralized exchange supports any ERC-20 token and specific infrastructure, including being integrated with digital wallets, such as MetaMask or MyEtherWallet. The reason it is so popular is simple – it’s completely open-source and anyone can use its code, thus laying the groundwork for their own decentralized exchange. Furthermore, users can list their own tokens and have full and permanent control over the assets.
When it comes to this AMM, most users and analysts define it as complementary to Uniswap. It is built on Ethereum and can be compared to an index fund, as users can create such funds in their portfolios. Balancer pools are public or private liquidity pools, in which smart contracts consistently provide a balanced proportion of assets, even if the prices of shared tokens may vary. What sets Balancer apart is that a pool can integrate up to 8 different tokens.
Like any AMM, this is a decentralized protocol that allows the exchange of tokens without intermediaries, based on KyberSwap – its exchange. It is based on a Decentralized Autonomous Organization (KyberDAO) made up of holders of its native token, KNC (Kyber Network Crystal). It can be integrated with dApps, DeFi platforms, and crypto-wallets, and although it can be implemented on any blockchain, it works on Ethereum, starting in December 2020.
This AMM is characterized by low exchange fees and low slippage. This is possible because all the liquidity pools it includes are made up of tokens that behave very similarly. However, this means that liquidity providers also receive lower fees for storing their tokens in these pools. Still, to encourage them, Curve can be integrated with other external DeFi protocols and offers rewards in CRV tokens.
How to use Automated Market Makers
If you want to successfully use an AMM protocol, you need to access its online platform. At the same time, when creating your account, you’ll need to connect a digital wallet to it.
Subsequently, you can choose what asset you want to exchange and follow the steps to confirm transactions from and to your digital wallet.
As with an exchange, if you want to participate in a liquidity pool, you also need to connect the digital wallet and set in the liquidity provider section how many and what kind of assets you want to include in that pool.
As a rule, to successfully contribute to these liquidity pools, you will need to offer both types of assets that participate in the exchange – that is, if an ETH is, let’s say, the equivalent of 400 Dai, then it will include 1 ETH and 400 Dai simultaneously.
After you successfully trade the assets in that pool, you will receive a token attesting that you are participating in that liquidity pool.