What are automated market makers? About the success of Uniswap

In 2020, DeFi laid the building blocks for an entirely new financial system: payments, loans, asset issuance and swaps. This was achieved through a combination of stablecoins, automated market makers, liquidity mitigation, dynamic redistribution Profit Revolution scam of the liquidity pool, smart asset management, flash loans and more.

The growth of DeFi in 2020
Today we are looking at one of these aspects responsible for the explosive growth of DeFi in 2020: automated market makers (AMMs).

Growth of fixed value at Defi in 2020

Central Limit Order Books (CLOB) are the backbone of modern crypto exchanges. They work by aggregating bids and requests (limit orders) from market makers at different price points for different asset pairs. CLOBs generally work reasonably well with centralised exchanges, but the CLOB model breaks down when the entire exchange moves to the blockchain and goes decentralised.

CLOB on DEX does not work
The reasons are simple: every bid and every question, and every adjustment to those bids and questions, incur transaction costs (on Ethereum that is gas) because they are recorded on the blockchain. In addition, every order can theoretically get a front-run, as orders are prioritised based on how much transaction costs you pay instead of how fast you are. Some projects are working on layer 2 solutions to these problems with on-chain order books, but at the moment it is too expensive to manage an order book on-chain.

Automated market maker
Uniswap is a decentralised stock exchange that uses an automated market maker. The concept was first proposed by Vitalik Buterin at the end of 2016 and developed by Bancor in mid-2017, but Uniswap made AMM mainstream. SMPs solve the problem of maintaining a CLOB by locking trading pairs‘ assets into liquidity pools. There are several types of SMPs today, but they all use something called a ‚market maker with constant functions‘ to price assets and ensure that each order is filled for each pair listed.

For example, the ETH-DAI pair on Uniswap contains equal amounts of ETH and Dai at a ratio of $600: $1. If there is a $12,000 liquidity pool to trade against, this means that 10 ETH and 6,000 Dai are locked into the SMP.

Criticism of SMP
The criticism of SMPs was that they were only good for small transactions. Trying to execute a USD 1 000 transaction for ETH in a market with only USD 12 000 liquidity would have a huge impact on the price of Ethereum. This is quite separate from trading on centralised exchanges.

Enough advantages
However, despite possible slippage, SMPs are an innovation that allows you to bypass large, central stock exchanges. Not only for safety reasons (self-care), but also for convenience and accessibility. SMPs do not have as much compliance overhead for every market they support, and anyone can immediately start a market for a new asset on Ethereum. Centralised exchanges are no match for this. SMPs are very fast and convenient for trading synthetic tokens (think of a synthetic bitcoin on Ethereum).

Putting everything into perspective
Ryan Selkis of Messari says that decentralised fairs are not nearly as popular as centralised fairs. He makes a good comparison. Selkis sees SMPs versus CLOB in the same way as Bitcoin versus global currencies. Bitcoin is a bad currency compared to the US dollar, but a very good currency compared to the Argentine Peso or Venezuelan Bolivar or Sudanese pound. As bitcoin strengthens and overtakes other currencies, it rises on the currency rating.

Similarly, Uniswap is a ‚bad exchange‘ compared to Binance, but a very good exchange compared to centralised exchanges outside the top 50 in terms of volume. It is only a matter of time before Uniswap is in the top 10 in terms of volume. In the future, most liquidity for most markets will flow through decentralised exchanges, and SMPs will be a crucial part of that story.