What is AMM?

TLDR;

Automated market makers (AMMs) are the backbone of decentralized exchanges (DEXs), which allow users to trade cryptocurrencies directly without a middleman. AMMs are like automated traders that make trading possible by removing the need for any  centralized trading middleman. In this guide, we'll explain how AMMs function.

What are Automated Market Makers (AMMs)?

In decentralized finance (DeFi) lending protocols, an Automated Market Maker (AMM) is often used to facilitate the borrowing and lending of digital assets. While AMMs are commonly associated with decentralized exchanges (DEXs), they can also be integrated into lending platforms.

In a DeFi lending protocol with an AMM, users can deposit their assets into liquidity pools, which act as a source of funds for borrowers. The AMM algorithm automatically sets interest rates based on the supply and demand dynamics within the pool. As the demand for borrowing a particular asset increases, the interest rate goes up to incentivize lenders to supply more of that asset.

Borrowers can take out loans by providing collateral in the form of other digital assets. The AMM determines the loan-to-value (LTV) ratio, which represents the maximum amount a borrower can borrow based on the value of their collateral. If a borrower fails to repay the loan, the collateral can be liquidated to compensate the lenders.

The AMM plays a crucial role in maintaining liquidity and stability within the lending protocol. It ensures that there are sufficient funds available for borrowers and incentivizes lenders to participate by offering them a portion of the interest earned on loans.

On the other side Market makers on centralized exchanges facilitate liquidity provision for trading pairs, while decentralized exchanges (DEXs) aim to eliminate intermediaries and enable direct trading from non-custodial wallets. 

Also read: What is decentralised money market?

How do Automatic Market Makers (AMMs) work?

In DeFi platforms like Umee, automatic money markets (AMMs) play a key role in facilitating lending and borrowing activities. Here's how they generally work:

- Liquidity Pools: AMMs operate through liquidity pools, which are pools of funds provided by users. These pools consist of different digital assets that can be lent or borrowed.

- Interest Rates: The AMM algorithm sets interest rates dynamically based on the supply and demand within the liquidity pools. When there is high demand for borrowing a specific asset, the interest rate increases to incentivize lenders to provide more of that asset.

- Borrowing: Users who want to borrow a digital asset can do so by providing collateral in the form of other assets. The AMM calculates the loan-to-value (LTV) ratio, which determines the maximum amount a user can borrow based on the value of their collateral.

- Collateralization: To secure the borrowed funds, borrowers are required to overcollateralize their loans. This means that they need to provide collateral worth more than the borrowed amount to protect lenders from potential default. You can understand more about this here.

- Automatic Liquidations: If the value of the collateral drops below a certain threshold, the AMM system may automatically liquidate a portion of the collateral to repay the borrowed funds. This ensures that lenders are protected from significant losses.

- Fees and Rewards: Lenders who provide liquidity to the pools earn fees from the interest paid by borrowers. These fees are distributed to the lenders in proportion to their contribution to the liquidity pool. Some platforms may also provide additional incentives, such as governance tokens, to attract liquidity providers.

Also read: What is money lego?

Conclusion

In conclusion, an automated market maker (AMM) is a fundamental protocol powering decentralized exchanges (DEXs) and lending protocols. AMMs revolutionize DeFi by eliminating the need for intermediaries and centralization. These autonomous trading mechanisms use smart contracts to determine asset prices and provide liquidity. This innovative approach promotes accessibility, efficiency, and transparency in the crypto ecosystem.