What is an automated market maker (AMM)?
An Automated Market Maker (AMM) is a computer software which operates a trading platform to make orders based on real time data and market conditions. The AMM provides liquidity for many financial instruments. This guide contains everything you need to know about AMM.
The US Securities and Exchange Commission (SEC) has defined an automated trading system as a computer programme that generates or routes orders to a market centre, usually without any human intervention. The main purpose of an automated market maker is to ensure a continuous flow of orders in all market conditions, providing two-way quotes at the best prices available so that investors can trade virtually 24/7.
With market makers on both sides of a trade, traders no longer need to worry about market direction when entering a trade, which means that market makers reduce transaction costs for the individual trader. In addition, if there were no market makers, traders would have to hold ‘quotes’ as there would be none.
Market makers are vital to any particular financial market.
They provide liquidity by specifying both rates and queries at all times, while maintaining the necessary price continuity that allows traders and investors to have confidence in the prices quoted.
What is an automated market maker?
An automated market maker (AMM) is a trading system designed to provide liquidity in the stock, options and futures markets without the need to own or deliver a security. It is an electronic trading system in which the owner offers to buy and sell shares at quoted prices with little or no price variation.
AMM continuously monitors share prices on a number of exchanges and determines what the fair bid/ask price of each security is. This information is posted on a visible quotation board, which traders can access via the internet.
How AMM works
AMM provides traders with a fully automated trading tool to make profits without human emotion or error. The technology behind AMM is based on algorithmic trading.
AMM provides both manual and automated signals in one setting which allows traders to easily start profiting from their initial trading investment. Traders can choose to either follow the automatic signal which will start trading instantly or they can switch to manual mode and take control at any time if they wish. This feature gives traders more options, allowing them to react faster.
Liquidity Pools and Liquidity Providers
Liquidity pools are the fundamental building blocks of decentralised exchanges. They serve to connect traders with liquidity providers who have opposing trading interests. Liquidity pools allow all traders, even those with little capital, to trade on DEXs without loss or unreasonable risk.
DEX is an automated market maker. In a human approach, a trader visits an exchange and exchanges, creates buy and sell orders and waits for the order to be filled and processed before withdrawing his funds from the exchange. In contrast, there is no human involvement in filling your purchase order using AMMs.
Instead, algorithms fill your order compared to other users’ orders based on price/time priority.
This means that when you place a buy or sell order, you let the algorithm decide whether it is beneficial for them to match your order with orders other users may have, which they can profitably fill over yours.
The most popular AMM platforms
Let’s take a look at the most popular automated market maker platforms.
The AMM concept has gained momentum over the last year and now offers many platforms to choose from. Some AMM platforms have developed their systems with the specific needs of users in mind. Traders have created Uniswap (UNI) for traders, making it one of the most popular AMM platforms on the Internet today. Indeed, markets are not identical and there is no single solution that fits all. In the meantime, Uniswap can serve as an AMM platform or your main trading interface with any exchange you like.
The Kyber Network (KNC) is a decentralised, trust-free exchange running on the Ethereum (ETH) blockchain. AMM works as an intermediary between two parties seeking to trade assets via Kyber. For example, Christina wants to exchange her 10 KNCs for David’s AMM, who has X AMMC3. The AMM platforms operate autonomously and participants only need to send their transaction requests with desired parameters, such as buying/selling AMMC3 at what price or orders of magnitude. The Kyber Network monitors the entire AMM market, using smart contracts to collect AMMC3 liquidity data.
The benefits of using AMMs
Every time you trade on an exchange, central market makers facilitate your transaction. An AMM stands behind a quote, which is specified for a trader to place an order against. As long as its price is better than what the AMM can do for itself directly, they will execute against each other and the AMM will profit at some point.
AMMs provide a basic service in today’s markets. In particular, they increase execution speed, provide liquidity, and ensure fairness in pricing and trading practices by keeping spreads tight. They also reduce the costs associated with using liquidity pools or human traders who need to be paid monthly. AMMs reduce price volatility by gathering information from the best available sources (other AMMs) and averaging them.
Disadvantages of AMMs
Automated market makers have several disadvantages that make them undesirable from an investor’s perspective. AMMs maintain the best rates and offers on stocks. But often your AMM will not be able to determine the correct bid price. As a result, AMMs can lead to significant losses and affect market performance. AMMs do not necessarily add liquidity to the market, which means that they can only act on one side of the transaction, as AMMs typically deal in large blocks of assets. AMMs do this by looking for the highest bid prices or lowest offer prices available at any given time, rather than trying to get you into a better position.
AMMs are also sometimes called predatory traders because they buy out every other available stock.
AMM prices are opaque, making it impossible to assess and monitor their impact on the market. Many AMM algorithms involve many very complex mathematical formulas that are too complex for human intervention or oversight. AMMs often provide liquidity to illiquid stocks. However, AMMs can cause sudden failures that regulators cannot turn off during a crisis. While AMM orders can reduce spreads and increase liquidity, AMM volume ratios have increased over the years. AMMs want more money per trade without providing enough better service, leaving other traders worse off. Some critics believe that AMM activities are severely distorting share price levels.
Automated market makers are an integral part of the DeFi space. While they have some limitations, their ability to be implemented is invaluable.
AMMs, the automated version of market makers, are still in their infancy. They have an elegant design and functionality. But they face limitations that future releases can overcome, such as lower fees, less difficulty investing and incentive marketing strategies.
We — the Intelfin team — are committed to providing our clients with tailored advice, regardless of their level of experience, so that they can optimise their profit potential while driving innovation with automated hybrid technology and arbitrage that continues to push global boundaries.