Market makers are market liquidity providers. Stock exchange market makers have functioned for years quoting both buy and sell prices. These market makers make their money on the difference between buy and sell prices, the spread. The benefit to the market is that market makers help reduce daily trading volatility. In the world of decentralized finance an automated market maker provides this function for those trading cryptocurrencies.

What Is an Automated Market Maker?

Within a decentralized exchange there is an autonomous trading mechanism that gets rid of financial entities or centralized authorities. This automated market maker allows any two system users to carry out transactions without any intermediary. As with traditional market makers on stock exchanges an automated market maker provides liquidity and reduces intraday volatility by instantaneously connecting a potential cryptocurrency buyer with an interested seller.

Automated Market Maker Algorithm

The algorithm of an automated market maker is the formula or set of formulas it uses to arrive at price solutions. These include price aggregators, mechanisms for efficient arrival at price solutions, and solutions that are designed to provide maximum system liquidity. There are many of these formulas with complicated mathematical underpinnings. The bottom line is that such systems insert themselves as the “middleman” in supporting peer to peer cryptocurrency transactions.

Dynamic Automated Market Maker

Traditionally an automated market maker system contains assets constrained by a mathematical relationship. A newer approach is to use an “oracle” or predefined mathematical function that speeds up the connection between buyer and seller and makes the process faster and more efficient. Rather than working through a person such as in a stock exchange or a computer these dynamic automatic market makers function via tokens on the blockchain.

Automated Market Maker Crypto

The original idea that launched the first cryptocurrency, Bitcoin, was that financial transactions could be handled separate from traditional financial institutions. The automatic market maker works in in this context by connecting buyers and sellers without the need for an intervening institution. All activities are confined to the blockchain and managed by specially designed mathematical algorithms that make transactions fast, efficient, and equitable.

Automated Market Maker Example

So, you want to purchase one Bitcoin. You work with a decentralized exchange that functions on the blockchain. An automated system handles your order. If there are currently no sellers this means that liquidity is low and prices may be higher. If there are lots of sellers, liquidity is high and you might get a better price. The automated market maker matches your purchase order with multiple sale orders and finalizes the connection between buyer and seller and you get your bitcoin while the seller gets his or her payment.

Automated Market Maker Formula

An automated market maker formula can be quite complex but the individual parts are basic mathematical equations. An example is Uniswap where x times y = z indicates the amount of a given token in its liquidity pool (x) and the amount of another token in that pool (y) while z is a fixed constant which tells us that total liquidity in that system will always be constant. Depending on the goal of the automated market maker system the formula or set of formulas will differ to favor efficiency, pricing, limited volatility, and more.

Defi Automated Market Maker

Automated market makers are not limited to buying and selling of cryptocurrencies. In the world of decentralized finance (DeFi) these systems are used to help secure loans, set rates, and determine loan conditions. Because these systems work on the blockchain they can provide access to a significantly larger pool of loan applicants and individuals or companies wishing to supply loans than when one goes to their neighborhood bank looking for a loan. Likewise, applicants may have significantly better access to favorable terms.