Welcome to PYMNTS’ series on decentralized finance, or DeFi.
In these articles, we’ll be looking at every part of DeFi — the biggest, hottest, most rewarding and risky part of the blockchain revolution. At the end of it, you’ll know what DeFi is, how it works, and the risks and rewards of investing in it.
See Part 1: What is DeFi?
See Part 2: What Are the Top DeFi Platforms?
See Part 3: What Is a Smart Contract?
See Part 4: What is Yield Farming and Liquidity Mining?
See Part 5: What Is Staking?
See Part 6: What Are DeFi’s Top 10 Uses?
See Part 7: Unpacking DeFi and DAO
See Part 8: DeFi’s Very Real Risks
See Part 9: What Are the Top DeFi Blockchains?
See Part 10: What’s Real, What’s Hype, What Matters
See Part 11: What Is An Algorithmic Stablecoin?
In this series, we’ve gone into what DeFi is and how it’s used. But if you want to know how DeFi works, and how its tools can be used by other parts of the financial world, you need to understand the automated market maker, or AMM.
Let’s start with a traditional market maker, which is essentially a wholesaler who ensures a smoothly functioning market by providing liquidity. The market maker is generally a large bank or financial institution which guarantees to buy securities (bid) at a specified price and sell them (ask) at another price, so a seller does not have to actively seek out a buyer who want a specific amount of a specific share at a specific price. Market makers turn a profit on the bid-ask spread.
That is a time-tested system used at many exchanges. It is also a financial middleman, something crypto in general and DeFi in particular abhor. Getting rid of them was, after all, the core goal of Bitcoin’s creator.
Without any centralized management at all — at least in theory — decentralized exchanges (DEXs), in particular, do not have room for traditional market makers.
While a DEX could automate the process of matching buyer and seller directly, it would have the same problem: Excluding major cryptocurrencies like bitcoin, Ethereum’s ether and a few others, there would be a substantial liquidity problem in most of the thousands and thousands of cryptocurrencies.
So how do you go about decentralizing a centralized and cash-intensive function? You crowdsource it.
Top DeFi exchanges like Uniswap, SushiSwap, PancakeSwap, Curve Finance and Balancer all use AMM smart contracts, running a combined trade volume in the billions of dollars a day.
The mechanism that AMMs use is the liquidity pool, which offers anyone with some crypto to invest a return based on transaction fees, and possibly a reward in the form of the pool’s own tokens — which is where liquidity mining comes in.
See also: PYMNTS DeFi Series: What is Yield Farming and Liquidity Mining?
Liquidity providers lock their crypto — let’s say ether, or ETH — into a pool, getting the pool’s own tokens in exchange. When they want to withdraw their ETH, they burn the pool’s tokens.
These are governance tokens with a vote in the decentralized autonomous organization (DAO) that manages to pool on issues such as the withdrawal terms for crypto locked in the pools and the size of the fees charged.
Pools often compete based on fees size, the amount of liquidity and the trade volume of the tokens in question. They are, of course, subject to hacks and frauds, just like the DEXs and centralized crypto exchanges.
Yes, but…
It’s not quite that simple. DEXs’ liquidity pools can handle specific trading pairs — for example, ETH and stablecoin USD Coin as ETH/USDC — or in some cases, the biggest pools have several different cryptocurrencies.
Let’s say ether is priced at $3,500 and USDC is $1. If you put in one ETH, you’ll get 3,500 USDC — minus the trading fee. That fee goes back to the pool’s members based on their percentage of the total pool funds.
There’s a big “but” at this point — slippage.
When the trader agrees to the swap is not when the trade is completed by being written onto the blockchain. On Ethereum, the block time is generally 12 to 15 seconds — meaning that there’s time for the price of the very volatile cryptocurrencies to change between the ask or bid and the transaction taking place.
With large orders or expensive cryptocurrencies, this can be a killer when volatility is high. However, as DEXs move to Ethereum competitors like Solana and Cardano with far faster block times, slippage can become a thing of the past.
Read more: PYMNTS Blockchain Series: What Is Solana?
See also: PYMNTS Blockchain Series: What is Cardano?
And with no middlemen, no managers to pay and growing liquidity and falling slippage, AMM-powered DeFi exchanges may have a bright future.
