Automated Market Maker: Key to Decentralized Exchanges?

An Automated Market Maker (AMM) is a tool used on decentralized exchanges to allow for the automatic trading of digital assets. This is done by the use of liquidity pools rather than conventional buyer and seller markets.

In our recent article on liquidity pools, we likened automated market makers to robotic lifeguards overlooking concrete swimming pools full of fruit.

If you’re thinking ‘Hold on…what?!’, don’t worry, we’ll revisit the analogy here!

Imagine you’re standing in a field, and in front of you is an empty swimming pool with a concrete wall splitting it in half. Sitting on a tall sentry chair is a robot-lifeguard watching over the pool.

All of a sudden, two trucks back up to the opposite ends of the pool – one truck full of apples, the other full of bananas. Before the trucks can empty their respective fruits into the two sides of the pool, the robot-lifeguard tells the truck drivers that they can only deposit equal dollar amounts of apples and bananas into each side.

If you’re thinking the robot-lifeguard (AKA the automated market maker) sounds like a bit of a tyrant, you’re right – it rules the pool with a mathematical iron fist in order to facilitate trustless, immediate trading through the pool. Without the robot-lifeguard in our analogy, the trading of apples and bananas through the pool would get messy very quickly.

Decentralized exchanges rely on automated market makers in order to work – without AMMs we’d be stuck with the inefficient order book system of the past. Luckily for us they do exist, so we can trade around the clock without having to wait for a buyer or a seller to agree on a price.

How to Make Money from an Automated Market Maker

Automated Market Makers can make users money when they set up a liquidity pools on a decentralized exchange (or add liquidity to an existing pool). Whenever a trade occurs through the pools, liquidity providers earn fees.

The most famous decentralized exchange (DEX) is Uniswap v3, where liquidity providers earn a portion of the protocol’s 0.3% trading fees. A portion of 0.3%?! How can that be worthwhile?! Well, it absolutely can be.

At time of writing, Uniswap’s 24-hour volume on V3 alone is over US$1.3billion. Because the volume that moves through the popular pools is so large, even small-time liquidity providers can make a tidy profit just for adding their crypto to the pool.

Conversely, if you add liquidity to a less popular pool then you will own a larger percentage of the pool and will receive a larger share of the rewards. Finding the absolute most profitable pool can be a real head spinner because the pools are changing constantly.

If you decide to become a liquidity provider, you can thank a robot-lifeguard (AKA an automated market maker) for enforcing the rules of the pool, thereby facilitating trading and making your sweet gains possible

What are single-sided pools?

As the name suggests, single-sided liquidity pools only hold one crypto asset, which means there is no risk of impermanent loss.

Put simply, impermanent loss is where the fees you earned for providing liquidity are worth less than the gains you would have enjoyed if you had simply held the assets in your wallet and not added them to a liquidity pool in the first place.

Is adding liquidity to a single sided pool the same as ‘staking’ on centralized exchanges like Coinbase? Not really, even though it may seem similar.

When you stake an asset on a centralized exchange, you lose custody of the asset, and the centralized exchange can go and do whatever they want with it. In return, you get a yield, often a very healthy yield compared with traditional finance like your bank.

In contrast, DeFi protocols like Uniswap V3 and PancakeSwap offer single-sided liquidity providing, often with higher yields than centralized lending exchanges and protocols, and you don’t have to give up custody of your crypto. Remember, as the saying goes, ‘Not your keys, not your coins’.

Is the Liquid Loans Stability Pool a single-sided pool?

Technically no, but this type of pool is a bit special, and very clever. The way it works is that Stability Providers add USDL stablecoin to the pool, which helps support the health of the Liquid Loans protocol. As a reward, Stability Providers receive yield in the form of LOAN token (which they can stake in the protocol’s Staking Pool), and PLS when liquidations occur.

This is what makes the Stability Pool special – by providing stability, you’re essentially agreeing to buy a proportional share of PLS (at a discounted rate) from liquidated Vaults when liquidations occur.

So if you’re a small-time Stability Provider, you may lose a little bit of your deposited stablecoin, but it will be replaced with discounted PLS that you can either sell or add to a Vault (if you have created one). Plus, don’t forget the healthy amount of LOAN token you’ll be receiving for providing stability to the system.

How much can the Stability Pool yield?

Liquid Loans is forking Liquity, and at time of writing, the all-time stability providing APR on Liquity is 24.4% – not bad for yield on a stablecoin! Certainly better than what your bank will give you, and better than any centralized yield platform in the crypto world (that we have been able to find) is offering on stablecoins.

Learn more about the Liquid Loans Stability Pool here.