AMM DEX

The Automated Market Maker (AMM) is not new in cryptocurrency, particularly in the Decentralized Finance sector (Defi). Decentralized Exchanges (Dex) use it in their operations. However, because the idea is still relatively new in NFTs, many products have emerged to aid in its adoption, including UniclyNFT, bridge split, Frakt, NFTx, Solvent Protocol, Tensorswap, and others. These automated NFT markets were created to help traders with liquidity.

While they may have been operationally successful, many NFT traders do not use them, and some need to be made aware that such applications or operations exist; this is very unlikely to be the case with Defi traders who are very familiar with the concept.

What exactly is an AMM?

If you've ever traded on a Decentralized Exchange such as Uniswap, Curve, Pancakeswap, or Raydium, you've used an Automated Market Maker. If you've never done it before, don't worry; AMM is simply trading in a market where only one party is involved in a transaction.

Unlike centralized exchanges (Cex) such as Binance and Coinbase, where transactions are carried out peer-to-peer, requiring an additional party as in a traditional market, in an AMM, the trader's only interaction is with the smart contracts that enable the transaction to take place.

What is the operation of an Automated Market Maker?

When a trader exchanging assets or tokens in an AMM requires liquidity, liquidity pools represent the other party's role that provides liquidity as an exchange for the tokens, as in human or centralized markets.

The provision or supply of funds by people known as liquidity providers to enable enough liquidity for AMM trades is referred to as a liquidity pool. The AMM determines the percentage of these liquidity providers earn from each trade that uses the pool. The liquidity already in place in any Dex using AMM is a result of a pool obtained from the funds of liquidity providers. Because the liquidity is already available, there is no need for an additional party to provide liquidity because the role of such a party has been assumed.

In the absence of another party to determine how much tokens or assets should be priced or exchanged, an automated market maker uses a mathematical formula to calculate prices. The formula may differ depending on the AMM; for example, uniswap uses x*y =k.

There must be a pair for trading to occur on an AMM, which means exchanging or trading one asset for the other, such as ETH/DAI or SOL/DUST. x represents the value of one token in the pair, y represents the value of the other token in the pair, and k is a fixed constant. The fixed constant (k) represents the total liquidity of the pool, which should remain stable.

What exactly is a liquidity pool?

Funds are added to liquidity pools by liquidity providers (LPs). A liquidity pool can be considered a large pile of funds against which traders can trade. LPs earn fees from trades in their pool in exchange for liquidity to the protocol. In the case of Uniswap, LPs deposit an equivalent value of two tokens to the ETH/DAI pool, for example, 50% ETH and 50% DAI.

So anyone can become a market maker. Indeed! It is simple to add funds to a liquidity pool. The protocol determines the rewards. Uniswap v2, for example, charges traders 0.3%, which is paid directly to LPs. Other platforms or forks may charge lower fees to entice more liquidity providers to join their pool.

What is the significance of attracting liquidity? Because of the way AMMs work, the more liquidity in the pool, the less slippage large orders may experience. This, in turn, may draw more traffic to the platform.

Slippage issues will vary depending on the AMM design, but it's something to keep in mind. Keep in mind that an algorithm determines to price. To put it simply, it is determined by how much the ratio of the tokens in the liquidity pool changes after a trade. There will be much slippage if the percentage varies.

To take this a step further, imagine you wanted to purchase all of the ETH in the ETH/DAI pool on Uniswap. You couldn't, could you? You'd have to pay an exponentially increasing premium for each additional ether, but you'd only be able to buy it some from the pool. Why? It is due to the formula x * y = k. The equation no longer makes sense if either x or y is zero, indicating no ETH or DAI in the pool.

However, this is only part of the story about AMMs and liquidity pools. When providing liquidity to AMMs, you must keep one thing in mind: impermanent loss.

What precisely is impermanent loss?

Impermanent loss occurs when the price ratio of deposited tokens changes after they have been deposited in the pool—the more significant the difference, the greater the impermanent loss. As a result, AMMs work best with token pairs of comparable value, such as stablecoins or wrapped tokens. Impermanent loss is also negligible if the pair's price ratio remains within a narrow range.

However, if the ratio changes significantly, liquidity providers may be better off simply holding the tokens rather than adding funds to a pool. Even so, Uniswap pools like ETH/DAI, which are highly vulnerable to short-term losses, have been profitable due to the trading fees they generate.

"impermanent loss" isn't the best way to describe this phenomenon. "Impermanence" assumes that the losses are mitigated if the assets revert to the prices at which they were initially deposited. However, if you withdraw your funds at a different price ratio than when you deposited them, you will incur permanent losses. In some cases, trading fees may mitigate losses, but it is still essential to consider the risks.

When depositing funds into an AMM, exercise caution and ensure you understand the implications of impermanent loss. If you want a more in-depth look at impermanent loss, check out Pintail's article.

How do NFTs trade in an automatic market maker?

NFTs are one-of-a-kind tokens that represent assets, whether digital or virtual. The idea has always been that NFT trading can only be done by two parties, similar to how physical assets are traded. Marketplaces have been developed to facilitate these transactions between the seller and the buyer.

These marketplaces are custodial; after a transaction, the NFT leaves the seller's wallet and is held by the market until a buyer purchases it. The marketplace places' temporary possession of the NFTs grants them full authority over the NFTs, which they may exercise, to the chagrin of the asset owners. AMMs was initially rejected due to centralization and excessive human intervention.

This resulted in the development of AMMs for trading NFTs, in which NFT owners have full custody of their NFTs until the transaction is completed and can also trade NFTs without a buyer. Automated Market Makers for NFT trading also use a liquidity pool from liquidity providers' funds. Because liquidity is already available, a third party, such as a buyer or seller, is not needed.

Also, liquidity was low in NFTs, most likely due to low volume or hype on a specific NFT. However, liquidity in the system and the hands of traders is required to create a more efficient and performing market. As a result, the creation of an Automated Market in which traders do not need to wait for a seller to be interested in their assets to obtain liquidity; instead, they can trade it against the available liquidity pool.

Sellers and buyers of NFT only need to connect their wallet, search for the NFT they want to sell or buy, and trade it against any other token or currency of their choice, as long as it has a liquidity pool on the marketplace. NFTs could also be traded for one another rather than for liquidity on an AMM.

In contrast to centralized markets, where a seller must list NFTs one after the other, AMMs may create a very efficient trading platform for traders. In an AMM, a seller can generate a list order to list all NFTs at a specific or variable price. A seller could input a particular percentage increase in the cost of the listed NFTs upon selling one NFT when listing the NFTs.

For example, if a seller lists 10 NFTs for 1 ETH at a 10% increase price when the first one sells, the next NFT's price becomes 1.1ETH, and so on. Instead of constantly checking floor prices on centralized marketplaces and adjusting listing prices, this method allows for the most efficient and effective exit from an NFT.

In the case of a buyer, one can effectively buy NFTs as the price decreases once the range or percentage of your choice has been entered. You can effectively accumulate NFTs at a lower cost this way. For example, if a buyer enters a 10% discount when purchasing 10 NFTs at 1E, the price of the next one drops to 0.9E, and so on.

To participate in this buying and selling, the entire amount that will be used in the transaction must already be deposited.

While this is a commendable advancement that makes trading more seamless and, more importantly, decentralized, some risks are still associated with trading NFTs in an AMM.

Because liquidity pools are a relative innovation, they may need to hold more liquid to support the volume of NFTs traded daily. Every day, an average volume of NFTs deals in Opensea and Magic Eden. It may take some time to get liquidity providers to fund the pool as much as that; in the meantime, trading NFTs may be slow and result in slippage, causing traders to lose money.

Because not all AMMs support all types of NFTs, attempting to trade an unsupported NFT on a specific automated market may result in a trader's funds being lost. Some AMMs charge higher fees than others; a trader's ignorance of this may result in a loss of funds.

Automated Market Maker in Defi has grown in popularity among Defi traders, whereas centralized markets are the norm in NFTs, with some being extremely dominant. It is unclear whether traders will fully adjust to AMMs instead of centralized markets, as some NFT traders have never used Defi protocols.

Regardless, it is an outstanding innovation that would allow more effective trading, liquidity, and thus more people to participate in NFTs. Aside from that, it gives the community the option of deciding whether to trade their assets with another party or exchange them on a liquidity pool, which is the essence of web 3. Web 3 was created to give the community the power to decide and make choices themselves.