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Arnaud Deblander
May 3, 2022 9:20 AM

Decentralized Finance is a real revolution for us investors and in aspects of technical evolution. Indeed, decentralized finance means no involvement of a third party. It is purely peer-to-peer. The recent rise of decentralized finance has seen the birth of several types of services: lending and borrowing services on the one hand, and exchange services on the other.

It is essential for an ecosystem that is decentralized to include exchanges that are also decentralized. The objective here is simple: to give users the possibility to exchange cryptocurrencies peer-to-peer, without a trusted intermediary.

For several years, projects have tried to replicate the operation of traditional exchange platforms, such as Coinbase or Binance, on the blockchain. Thus, we have seen the emergence of some decentralized exchange platforms based on order books, but unfortunately, the lack of performance of current blockchains as well as the absence of market makers have not allowed these solutions to come up top and be wisely adopted.

What is a market maker?

Market makers, whether a company (usually an investment bank) or an individual, are there to ensure the liquidity of the markets. They constantly quote prices, either buying or selling, for their clients and must normally quote regardless of the state of the market. To get paid, the market maker will use the spread, i.e. the difference between the buying and selling price, and they are also paid by the exchanges to provide liquidity.

One might think that the market maker has a vested interest in seeing that liquidity tends to be at its maximum. On the contrary, the more liquid a market is, the more competition between market makers will be exacerbated. Spreads are then low and tend to be close to the market maker’s transaction costs, thus eroding its margins. The most convincing example is the foreign exchange market. The different players are engaged in a fierce war, which leads to a reduction in spreads and therefore in the margins of each player.

In the crypto market, market makers are also commonplace on centralized exchanges, so they provide an immediate counterparty to market participants. They are sometimes used to support a project in its early stages, otherwise, the laws of the market could push the token down much too quickly.

From the above, it is evident that the role of market makers is significant in ensuring that the markets (be it crypto or legacy market) are functioning well. In the absence of market makers, there could be insufficient transactions and free investment activities. This will ultimately result in an illiquid market and ultimately, fewer trades.

Automated Market Maker

An automated market maker is a type of decentralized exchange (DEX) protocol, which relies on mathematical formulas to price assets. Instead of using an order book as in a centralized exchange (CEX), assets are priced according to an algorithm.

The formula behind this algorithm depends on each protocol. Uniswap for example uses x * y = k, where x is the number of one token in the liquidity pool and y is the number of the other token. In this formula, k is a fixed constant, which means that the total liquidity of the pool remains constant.

Other AMMs use different formulas depending on the use case they are targeting. What they all have in common is that the price of the assets is determined algorithmically.

How does it work?

An AMM works in a similar way to an exchange’s order book, as it contains trading pairs such as ETH/DAI. However, you do not need a third party (another trader) to make a trade. Instead, you interact with a smart contract that “does” the trade for you.

So there is no third party but everyone can be market makers? Yes indeed. The liquidity in smart contracts must be provided by users. These are called “liquidity providers” (LP).

Automatic market-making algorithms are based on liquidity providers who, in exchange for fees and LP tokens, provide liquidity to a pool to allow users to find a counterparty without much slippage.

Advantages of AMM on DEX

You don’t need KYC, there is no third party involved and you keep control of your funds at all times.

Although AMMs are very efficient, the execution speed is still lower and the transaction costs are higher than on centralized platforms. Moreover, even if it becomes more democratic, DEX trading platforms are less user-friendly than their centralized counterparts.

Conclusion

The market-making algorithms are inseparable from the advent of the DeFi. It would indeed be very unadvisable to use the order book model of the CEX as it would slow down the transactions.

Each decentralized platform has its own algorithm, but everything works on a liquidity provider basis. They provide the liquidity needed to trade a currency pair or pool. They are then rewarded with LP tokens and receive a portion of the trading fees.

With the fast-rising of DeFi, it is inevitable that this innovation will soon be widely adopted. DeFi replaces human trust with math-based trust, paperwork with smart contracts, and its legal framework is replaced by cryptographic enforcement while its third party audit with open source code and public ledger. Not to mention that DeFi aims to be faster and cheaper than today’s financial products.

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