By Nathan Ferguson
The following article is going to be about how Automated Market Makers operate. As the article is about a concept integral to many exchanges, it is to be ensured you learn about this concept in a detailed and contextualised manner.
Automated Market Makers, or AMM for short, are a concept at the core of an infamous and increasingly trending type of exchange; decentralized exchanges. Allowing so many important features related closely to the functioning of decentralized exchanges, they house features that may be similar to the traditional way Market Makers work, while some of them do not so much give Automated Market Makers their own distinct definition.
We will be exploring Automated Market Makers in the following manner:
- What is traditional Market Making?
- Why Automated Market Makers?
- How are Automated Market Makers different?
Before jumping on to the raw bulk of the topic points to be discussed, let’s have a basic introduction to the topic, shall we? Close your eyes and picture the stock market, maybe one of the exchanges in a major city. Either from movie adaptations or experience of having gone to one yourself, you will imagine groups of people shouting prices, trading various securities among one another as the hand of the clock strikes tick-tock every second.
Questions may arise in the minds of the curious; how are those prices decided? What if someone quotes a price higher than the one they are supposed to, and how are the “correct” prices maintained? What in the world does automated market makers have to do with all of this?
The aforementioned questions are just some of what we will be answering along with exploring the concept of Automated Market Makers.
What is traditional Market Making?
As stated in the example earlier, going to a stock market or even watching media adaptations of any of the popular exchanges such as the NYSE or even the NASDAQ, you will see a number of people shouting prices at each other, trading securities at particular prices. It is these prices that are the point of focus when discussing market making as they play a vital role in explaining what market makers do.
Market Makers are entities that actively quote both the bid and the ask prices of securities in a two-sided marketplace. Two-sided marketplaces refer to platforms where there are both buyers and sellers of particular securities.
Two-sided marketplaces will hence hold prices of both, selling particular security and the price at which the security is bought. The exchange uses terms such as the bid price to mean the highest price a particular trader on the market is willing to pay for a particular security. The term “ask” or “offer” price is used to define the lowest amount a trader is willing to sell a particular security for
Now one thing that is crucial to understanding what market making is and how it relates to Automated Market Making is understanding some key concepts such as market volatility in terms of two-sided marketplaces like exchanges.
Markets may be volatile, meaning that the volume of trading activity between numerous traders is so high that this, including other factors, cause the value of a wide variety of securities to vary second by second.
Sometimes by even less. Hence, volatile markets are markets where the prices of the numerous securities that are being traded have high chances of changing in value in a very short period of time. However, markets are not always volatile. Less volatile periods or even whole markets may exist as less volatile, where the prices of financial instruments tend to not change as much and hence, experience a period of less volatility.
These exchanges are usually open to a good amount of traders and most generally house numerous securities that can be sold as there may be thousands of traders (this number may be more or less depending on the exchange and timeframe we are talking about), the chances of the quotation of different prices for different financial instruments increase. For example, Trader A wants to sell their 0.5 worth of Bitcoin for $17,000, and at the same point in time, there are two Traders B and C who are willing to pay $16,800 and $17,200 for the very 0.5 worth of Bitcoin being offered.
Do note that in such scenarios, the factor in question is the quality a particular exchange brings to the table of its traders. Two-sided marketplaces, like the exchanges we are discussing, need to ensure a few factors so that they maintain their trader volume and focus on growing it.
A few features it can and most usually strive to offer are the following. Low costs for traders on their platform in order to trade on their exchange. This can mean low transaction costs. As this decreases, the amount of money taken home or invested in the market by a particular trader increases and hence, so does the exchange’s value among its users.
This one is an important factor for two-sided marketplaces to consider; however, the next factor is the one which we need to read in full focus and keep at the back of our minds as we read the next few paragraphs. Exchanges need to ensure speedy transactions, meaning that exchanges need to provide a very short time in which trade orders are executed.
This means the exchanges must possess a way to allow trade orders to be executed in record timings, despite many odds making it difficult to do so. This very last line is important to understanding what market making is.
Thus, this is what the landscape looks like so far. You have an exchange where there are thousands if not more of traders. You have these traders quoting “bids” and “asks” or “offers” on multiple securities per second. The biggest problem at hand? Ensuring a connection between these buyers and sellers. The biggest task is making sure that a trader who is selling something at a certain price is connected to the trader who is willing to buy the very security at the same certain price.
This was done using order books traditionally and is still the practice of so many two-sided marketplaces. In this practice, the prices quoted by numerous traders are recorded, and the trade order where there are matching prices from both sides is executed. This price is then the new price of that particular asset or security. That is, the price at which the particular asset or security was recently traded becomes its new price.
But let’s go back to an example quoted above in this article. What if such a scenario exists where Trader A wants to sell 0.5 BTC for $17,000 while there are two traders, B and C, who are willing to buy 0.5 BTC for $16,800 and $17,200? Respectively. Hence we arrive at a situation where the prices quoted do not match.
In this scenario, as the order book has to execute the order only when matching prices are quoted, the transaction is not executed until a matching price has been found. This means that certain security which turns illiquid.
Let’s take a quick bite of what liquidity refers to in market terms under the aforementioned context. Liquidity refers to the ease of the ability with which a certain asset, security or financial instrument can be converted to cash.
If there are a lot of buyers of a particular asset, the chances of finding a buyer willing to pay the exact amount as what the seller is willing to accept increases. Hence liquidity is dependent on how many people trade the very tradable item.
Moreover, liquidity is also dependent on the nature of the asset itself. Some tradable items are more frequently bought and sold than some and hence have an effect on their liquidity. Hence, liquidity is affected by factors, two of which are the nature of the asset and how many traders are engaged with it.
Markets with a high number of assets that can be easily converted to cash are hence called more liquid markets. Markets, where assets cannot be converted to cash so easily, are illiquid markets. This brings us back to the example where the trade of Trader A is not being able to be executed since a matching price cannot be found.
The very example aforementioned is one that is so simple anybody can say that it must commonly happen in exchanges, and they are right. So what do exchanges deploy to prevent illiquidity from freezing their markets? Market Makers.
Market Makers are firms or individual(s) who quote prices on both sides of the market. This means that they will sell and buy particular security in the exchange in order to keep the markets liquid.
Market Makers were required to be present in exchanges after the Financial Industry Regulatory Authority (FINRA) required exchanges to have market makers that quote both a “firm ask” and a “firm bid”. In theory, this is supposed to make the market more efficient and liquid.
To go back to the definition of market makers, where they are entities that quote both a bid price and an ask price in order to match the price of the retailers, we can now look at what would happen with the example we started this take on market makers with.
Market Makers will hence quote a price matching Trader A hence buying those 0.5 BTC and will also quote a price matching B and C in order to sell them their respective BTCs as well. By having market makers, you ensure your markets are liquid, as illustrated by this example.
However, do note that the recently traded price of a security is its current value at the time. Due to this, market makers are usually specialists who quote prices in such a manner in which they are supposed to be quoted.
Market Makers need to specify their bid and ask prices on particular securities and also specify the volume which they will trade at that particular bid or ask. This means market makers need to quote prices continuously and must stick to these parameters no matter what in order to keep the smoothness of transactions stable in the market.
Market Makers usually are compensated under regulations enforced by relevant authorities for holding in their inventory securities that may drop in value over time. They also earn profits by charging a spread on securities they cover.
For example, it might be observed that the bid price of a particular security is $100, and the asking price is $100.5. That extra 0.5 cents may go into the market makers’ pockets as profit.
Why automated market makers?
Indeed, that headline is a question that may arise in your mind. The following part is dedicated to explaining to you what Automated Market Making is by answering just that.
If we look at our recent history, in every single instance where there are centralized processes taking place where a majority of people have to rely on trusting a small minority of people for their assets, the majority tends to look for a decentralized approach.
In the way centralized exchanges work, the liquidity of the market is in the hands of Market-Making firms and individuals who act as essentially intermediaries in the trading process.
This is one of the many reasons why there was a need felt for decentralized exchanges to be founded. Where the operation of the exchange was not dependent on a small minority of people abiding by the principles they are supposed to, this entire notion was replaced by computer programs, which are run to merely execute tasks as they were coded.
Say hello to Automated Market Making. As the word ‘automated’ may give it away, Automated Market Making is just away. A lot of the tasks associated with market making are carried out by sophisticated computer programs running decentralized exchanges. It should be noted that automated market makers use smart contracts, code that executes once some predetermined conditions are met, at their core.
Instead of relying on traditional firms or specialists to make markets where they quote the prices they think are right, Decentralized exchanges use automated market-making where the market is “made”, relying on mathematical formula(e).
Hence, we can think of Automated Market Makers as computer programs that allow traders on Decentralized Exchanges to trade securities at a fair market price.
How are they different?
As traditional methods of market-making require relying on firms or individuals to act as market makers to keep liquidity in central exchanges, decentralized exchanges deployed Automated Market Makers.
They allow liquidity to be present in the exchange by using Liquidity Pools. In order to provide liquidity, there need to be prices quoted that best match the bid and asks of traders on both sides, and quoting prices means requiring money to buy those assets at those quoted prices.
A computer program cannot generate money and hence does rely on people for money, but those people do not control its operation. Instead, they deposit funds into the liquidity pool of the very Decentralized Exchange. Any individual can deposit their money into the liquidity pool of a particular decentralized exchange.
The computer program uses the funds collected in order to buy assets that best match the prices “ask prices” of traders. In doing so, they use the cash in the liquidity pool. Then the automated market maker sells the very asset at a price calculated using its coded formula or formulae, usually with a spread. For example, it may buy an asset at $10.0 and sell at $10.5, making a profit of 0.5 cents.
This profit and the profits of so many trades that take place on the decentralized exchange allows a good amount of profit to be collected, which is then distributed among the people who invested in the liquidity pools. This provides individuals or even firms with an incentive to ensure the liquidity of decentralized exchanges.
Another key difference to be noted which is brought about by the usage of automated market makers, is that there is no longer a need for order books to match prices manually. The automated market maker program deals with this issue automatically as it is coded to do so, its operation of which we illustrated above.
Hence, we can see how automated market makers are essential to decentralized exchanges. In terms of practical applications, Uniswap, Curve and Balancer are all Automated Market Makers currently in use today, while the industry looks forward to more with an increased number of features and versatility.
Conclusion
This article was dedicated to teaching individuals about automated market-making by comparing the automated variant with the traditional way markets are made. In order to carry this out, detailed explanations of both were offered, and differences explained why those differences were needed as well. Examples were also mentioned ensuring the readers get a good grasp of the theoretical explanation of certain operations and definitions.