AMM-based decentralized exchanges are the future of trading?

05/21/2021

Centralized exchanges act as a necessary bridge between fiat and crypto, facilitating unparalleled convenience. Nevertheless, industry leaders often see these types of exchanges as one of crypto’s single points of failure.

Another factor fueling the interest in DEXs (De-Centralized Exchange) is the security concerns. Although malicious attacks on exchanges have become less frequent, exchanges have repeatedly proven that they are vulnerable to hacks and information leaks.

More decentralized alternatives aim to provide an answer for those concerns, and one way to do it is through the use of the automated market maker on exchanges.

What are AMMs?

AMMs are the latest amongst DEX protocols. They do not rely on order books like regular exchanges but instead use mathematical formulas to calculate the price of assets.

AMMs also provide liquidity from different pools, excluding the need to have another user on the other side willing to trade. Trading is done by interacting with smart contracts or peer-to-contracts, which provide the price and liquidity necessary to execute trades.

A bit of AMM history

The concept was first introduced by Bancor back in 2017. However, hailed as the first true decentralized AMM, Ethereum-based Uniswap launched in late 2018, took the crypto world by storm due to its simple user interface and broad listing system. Currently, Uniswap is the world’s leading DEX in terms of trading volume.

Uniswap inspired multiple “variants,” one of which was SushiSwap, an AMM that ultimately established itself as Uniswap’s main competitor. As such, new types of AMMs have now started to bloom and have been diversifying the space, where different exchanges cater to different user needs.

The new AMM-based DEXs greatly facilitate exchanges between crypto assets and have surged in popularity ever since the DeFi summer of 2020. Currently, AMM protocols make up almost all of the total volume on DEXs and are considered an instrumental tool for the DeFi ecosystem. However, with innovation, there are always new problems and challenges that arise.

AMM Flavors

Each AMM tends to have its own unique price algorithms to harness liquidity in various ways and from different sources. In the current DeFi landscape, the three most dominant and distinct AMM protocols are Uniswap, Curve and 1inch.

As the second-largest DEX in the world, Curve inherited the core design of Uniswap but specializes as the first AMM optimized for stable asset pools. As a result of its architecture, Curve minimizes the risk of impermanent losses, solves the problem of limited liquidity, and offers one of the lowest trading rates across all DEXs.

Another popular trend in the world of AMMs is aggregation. The 1inch Network has pioneered this technique to have a dominant market share in the area. This method seeks to allow its users to save on fees when making large trades on low-liquidity pools, avoiding high slippage by routering the transaction through multiple liquidity pools.

AMM Negatives

One of the downsides inherent to the current AMMs is impermanent loss. Whenever liquidity pool tokens fluctuate in value, an arbitrage opportunity is created that will incur losses to the pool. The larger the fluctuation, the worse the losses will be. Therefore, AMMs work better if token pairs have similar values.

Although Curve minimizes this risk, the new version of Bancor seeks to prevent the problem completely. Allowing the creation of AMMs with pegged liquidity, Bancor v2.1 was designed to mitigate slippage and help solve the issue of impermanent losses.

There are other disadvantages to trading with AMMs.

On Ethereum, high gas fees have become an issue for the typical retail trader. Still, many exchanges have started to adopt layer-one and layer-two solutions to accommodate traders looking for smaller-size swaps.

Limited liquidity in some assets can also cause issues. Still, perhaps one of the most significant problems in the world of AMM trading is front-running bots that can take advantage of trades made by unwary buyers/sellers, creating faster transactions to profit from these traders.

Privacy in DeFi

Privacy has always been a central topic in the cryptocurrency world. However, all transactions and addresses are exposed on the blockchain and can be viewed by anyone. This level of transparency creates a danger for users sharing their public addresses. As such, privacy in the world of decentralized finance is becoming a highly demanded commodity.

As previously mentioned, front-running bots are a big issue in the DeFi sector, and they are a direct result of the lack of privacy found in the DeFi sector, where all transactions are exposed on the blockchain. Therefore, the use of privacy-centric wallets can mitigate this issue.

The Future of AMMs

On May 6, Uniswap released its long-anticipated v3 update. Aiming to maximize capital efficiency, the upgrade was a success and, in just one day, recorded more than twice the volume that v2 saw in its first month. Despite the achievement, many users are calling the launch a flop due to the complex user interface and soaring gas fees, which are even higher than v2’s.

While most of the DeFi ecosystem resides on the Ethereum blockchain, there is a mass migration of projects, like 1inch Network joining Binance Smart Chain and other rival DApp blockchains. Uniswap and other ERC-20-based protocols might be reliant on the success of Eth2, but the future looks to be in interoperability.

It’s tempting to assume AMMs protocols will be responsible for all on-chain liquidity in the future. However, DeFi is still a maturing technology, and its innovation is fast-paced. Even if AMMs can resolve their limitations, regulatory frameworks and new technologies might present threats to their dominance.

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