# Business development
Understanding Automated Market Makers (AMMs)
Red Rocket teamAug 21, 20246 min read
In This Article
What is an automated market maker (AMM) and how does it work? Types of smart contracts used in DeFi and AMM platforms The best AMM crypto platforms: Curve, Balancer, and Beyond How to build a decentralized exchange with the best smart contract platform Advantages of AMMs over traditional orderbook DEXs Future trends in AMM trading and DeFi innovation Final thoughts FAQWhen DEX exchanges first became available to users online, it created a big boom in the cryptocurrency market. Participants don't need an intermediary or trusted third party to execute transactions. Today, there are many decentralized exchanges where participants buy and sell hundreds of thousands of dollars worth of cryptocurrencies every day. Sounds impressive, doesn't it?
Such exchanges make it easier for everyone to execute the necessary transactions. However, there are several types of such exchanges, including AMM and Orderbook. To build a decentralized exchange, you need to learn the difference between these two technologies and choose the best solution. We are here to tell you more about Automated Market Maker (AMM), smart contracts, and real-life examples of successful AMM crypto platforms.
What is an Automated Market Maker (AMM) and How Does It Work?
Before you create your own decentralized exchange, you should learn more about how AMM technology works. The AMM is a technology where buyers and sellers directly exchange assets through a protocol without the presence of intermediaries. However, the trades happen through a pool known as a liquidity pool, which is regulated by a computational algorithm. The liquidity pool is the fundamental working unit of an AMM. This pool holds reserves of two digital assets. The proportion in which such assets are combined defines the exchange rate of these pairs.
Since all trades occur through the pool, the formula guarantees there is adequate liquidity for the swap between the assets while at the same time maintaining a fair price. This is a mathematical calculation to bring back the proportions to the new level in the pool after every trade to meet the set constant reserve ratio. The main difference between AMMs and conventional exchanges is that liquidity pools help to trade based on pre-determined parameters, with fewer hurdles in the process. Customers can contribute to giving markets a chance to earn fees on trades while not being dominated by high-frequency players and their complex order flow.
Types of Smart Contracts Used in DeFi and AMM Platforms
As you may already know, smart contracts serve as a security guarantee for two parties in a transaction. However, depending on the crypto platform, the set of smart contracts can be different. We have collected the key types of smart contracts that are used in DeFi and AMM platforms.
- Smart contracts for the creation of liquidity pools. Liquidity pools are created using smart contracts which enable users to deposit tokens into a pool or reserve. People consequently receive fees when other individuals trade in opposition to those reserves. These pools are used in AMM-based decentralized exchanges that offer users an accessible means of trading cryptocurrencies.
- Smart contracts for exchange (token swap). DEXs do not require a centralized authority and rely on smart contracts to enable automatic trading of tokens. Users define input and output goods, while the contract determines the price and negotiates trades between individuals.
- Smart contracts for commission calculation. In exchange, fee calculation contracts always pass a fraction of the trade fees to the liquidity providers. In this process, as trades transpire, such contracts accrue volumes with respect to provider rewards in relation to pool shares.
- Smart contracts for managing user balances. This is a type of contract that helps to monitor deposits, withdrawals, fees earned, and all other operations within wallets. They provide clear visibility to track the status and activity with the securities owned as well as the interactions had with them.
In simple words, the chosen set of smart contracts can determine the success of your future decentralized exchange. This is one of the most important points if you are thinking about creating your own crypto project.
The Best AMM Crypto Platforms: Curve, Balancer, and Beyond
If you think that AMM technology is something fantastic that nobody uses, it is not true. Today, there are many decentralized exchanges that have implemented AMM systems instead of the usual order book. Here are three of the most popular AMM-based crypto platforms:
1. Curve
Curve crypto exchange is a platform that has been available to users since 2017. Since then, it has expanded its range of cryptocurrencies and today offers trading of Ethereum, Polygon, Phantom and other currencies. Moreover, it is valued by users who trade stablecoins, where exchange rate prices have small fluctuations.
2. Balancer
The next place in our list is occupied by Balancer exchange. This is the platform that became popular among users from all over the world due to the implemented AMM technology. Today, the trading volume here exceeds the mark of 1.2 billion USD. It allows all users to hold up to 8 cryptocurrencies in Balancer Pools, which facilitates the creation of different trading strategies.
3. Uniswap
This is one of the most popular platforms where Automated Market Maker technology is used. Moreover, the developers of this project regularly improve the work of the system and introduce innovative updates. Users of the platform get access to trading Ethereum-based tokens. Their AMM system helps to automatically execute trades that correspond to customized smart contracts.
How to Build a Decentralized Exchange with the Best Smart Contract Platform? {"#how-to-build-a-decentralized-exchange-with-the-best-smart-contract-platform}
We are finally ready to get to the main part of this article that many of you have been looking for. Here we will share with you in detail the key tasks and processes that are necessary to create your own decentralized exchange with the best smart contract platform.
1. Select Required Functions
Create your own decentralized exchange starts with conducting an in-depth market analysis and understanding what features you want to implement in the platform. You need to answer the question of what potential users expect from your decentralized exchange in order to choose the right set of features. Decide what tokens will be available for trading on your platform, how trading will be implemented, what commissions will be applied to transactions, and more. A clear understanding of the project's functionality will make all the next steps much easier.
2. Define the Blockchain Platform
Obviously, the next task for you is to choose the most appropriate blockchain platform. There are many factors you should consider in this matter, including transaction fees and throughput. For example, Bitkion's throughput is about 10 transactions per second. This is actually very low and if you expect a large flow of customers, you need to choose another option. Other platforms of similar nature include Solana which can handle more transactions at a much lower rate compared to Ethereum.
3. Create Smart Contracts
DeFi smart contract development is one of the most important steps for your exchange to attract more and more customers. Once you have selected a platform to use, the next step is to develop the smart contracts that are going to underpin your decentralized exchange. Among the necessary smart contracts for a decentralized exchange, we can mention trade execution contracts, liquidity pools contracts, stable rewards contract,s and others. They will help ensure the correct operation of your future exchange and guarantee the execution of trades to users.
4. Develop Price Calculation System
Also, create a pricing mechanism that maintains proper asset ratios in the liquid pools when swaps are made. One of the most popular ones is a constant product formula which is used to impart capital efficiency to the liquidity providers. As an example, we can point to the crypto platform Uniswap, which uses such a formula. As practice shows, this is a reliable method that works effectively.
5. Create a Mobile App
When you have decided on all the technical features, you get the green light to build a mobile app. Why a mobile app? According to recent statistics, the majority of users use mobile gadgets to conduct various transactions related to cryptocurrency. Provide the following services; signup/login, funds transfer, swaps trading, liquidity services, yield tracking, and assistance. You should provide a logical navigation and intuitive interface.
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Advantages of AMMs Over Traditional Orderbook DEXs
Speaking about these two approaches for decentralized platforms, it's hard to identify a single winner. Each side has its pros and cons. Want to know how AMM system is better than traditional orderbook?
- Solving liquidity problems. First, AMMs are essential in addressing problems of liquidity since tokens can be exchanged directly for other tokens from smart contracts without requiring buyers and sellers to find each other. Such an automated liquidity also aids in the attraction of new users/projects.
- Greater user privacy. AMM offers users more privacy than orderbook DEX due to the absence of the need to list transactions on an order book. In the case of AMMs, users can directly engage with the smart contract to trade tokens without the need to engage in an open forum that will disclose their identities or transactions on the order book.
- Fewer manipulations. The pools of digital assets and the automated pricing model of AMMs also enable less manipulation as compared to the orderbook DEXs. The pricing algorithms and the pooled funds make it difficult for the wrong actors to manipulate prices and make big and sudden moves.
Which of these two solutions is better is for you to decide based on your goals of creating a decentralized crypto platform. Most importantly, the innovative AMM model helps solve the illiquidity problem.
Future Trends in AMM Trading and DeFi Innovation
As you may have already noticed, in this article we have mentioned a few popular crypto exchanges that use the AMM algorithm. Actually, there are many more such projects, and we can list them for hours. All this tells us that the popularity of AMM for use in decentralized exchanges is growing rapidly today.
Even though the order book model is used more often today, Automated Market Makers have a great prospect in the future. However, such exchanges will have to go through a lot to catch up with the traditional model.
Final Thoughts
Now you know more about what the AMM model is and how it works with a real-world example. In conclusion, AMMs are a relatively new form of DEX protocol that eliminates the need for orderbook and instead depends on specific formulas to determine the price of the assets. Accordingly, they act as market makers and supply liquidity pools of tokens which are paired with each other, thus enabling trading by using algorithms that reflect the supply and demand ratios.
They offer improved liquidity and more stable price levels in their transactions as opposed to the order book-based exchanges. In addition, it might offer users another way to earn money by making liquidity. However as with most decentralized finance products, there are potential disadvantages associated with AMMs.
Frequently asked questions
What are some of the problems associated with AMM?
High volatility can be a major disadvantage for decentralized exchanges based on the AMM model as they may experience huge price slippage. This is because the liquidity provided in the AMMs is anchored on specific reserve levels that are always available. One of the problems, which can occur when the trade volumes are high is the disconnect between the quoted price and the market price. Such slippage can be particularly detrimental to the trader as they exert stress and pressures that translate to losses.
How safe are decentralized exchanges with AMM?
Decentralized exchanges (DEXs) that use AMMs rely on smart contracts to facilitate trades, ensuring that transactions are executed automatically without the need for intermediaries. However, the safety of these exchanges is closely tied to the security of the underlying smart contracts. Errors in the code or vulnerabilities in smart contracts can lead to security breaches, potentially resulting in loss of funds or exploitation by malicious actors. Therefore, users should prioritize exchanges that undergo rigorous security audits and maintain a strong focus on protecting user assets.
What types of AMMs are there?
There are several types of Automated Market Makers, each with a different approach to managing liquidity and pricing. The most common types include Constant Product Market Maker (CPMM), Constant Sum Market Maker (CSMM) and Constant Mean Market Maker (CMMM). These models vary in complexity and are tailored to meet different needs within the decentralized finance ecosystem.
