Exploring the Basics: What is AMM DeFi and How Does it Work?

Basics of AMM DeFi:

Decentralized Exchanges (DEXs):

• Unlike centralized exchanges (CEXs) where orders are matched in an order book, DEXs operate using AMM protocols. DEXs allow users to trade directly from their wallets without relying on a central authority.

Liquidity Pools:

• AMM DeFi relies on liquidity pools, which are reserves of funds provided by users. Each pool consists of two tokens, often referred to as a “pair.” For instance, a liquidity pool could involve Ether (ETH) and a stablecoin like DAI.

Token Swaps:

• Traders can easily swap one token for another within these liquidity pools. The swapping process determines the ratio of tokens in the pool, which in turn influences the prices.

Constant Function Formula:

• AMMs operate on a mathematical formula called the “constant function” formula. This formula ensures that the product of the two token amounts in a liquidity pool remains constant, even as traders make swaps.

Price Impact and Slippage:

• When a large trade is executed on a small liquidity pool, the price can be affected due to the imbalance in token ratios. This is known as “price impact” or “slippage.”

Impermanent Loss:

• Liquidity providers (LPs) who contribute to liquidity pools are exposed to “impermanent loss,” a phenomenon where the value of the LP’s holdings changes relative to simply holding the tokens. Impermanent loss occurs due to the dynamic nature of the pool ratios as compared to holding tokens.

Liquidity Provider Incentives:

• To encourage users to provide liquidity, DEXs offer rewards in the form of trading fees and sometimes governance tokens. Liquidity providers earn a portion of the fees generated by trades.

Popular AMM Protocols:

• Some of the well-known AMM protocols include Uniswap, SushiSwap, PancakeSwap, and Curve Finance.

How AMM Works:

• Initialization:
• Users add equal values of two tokens to create a liquidity pool. The tokens’ values determine the initial price ratio.
• Trading:
• When traders swap tokens, they change the pool ratio. The constant function formula ensures that the product of the token amounts remains constant.

Price Adjustments:

• As more trades occur, the pool ratio shifts, affecting the token prices. This mechanism helps align prices with external markets.

Liquidity Provision:

• Liquidity providers add or remove tokens from the pool to maintain balance. Their actions influence the token prices within the pool.

Fees and Rewards:

• Traders pay fees for using the liquidity pools. These fees are distributed among liquidity providers as incentives.

AMM DeFi revolutionized the way cryptocurrencies are traded by introducing decentralized, peer-topeer trading mechanisms. It allows anyone to participate in trading and liquidity provision, contributing to the growth and vibrancy of the DeFi ecosystem.