In our previous posts, we have covered in detail what sets Solana apart from other blockchain ecosystems and why Solanax holds the potential to redefine the Decentralized Finance (Defi) landscape while standing out among other Automated Market Maker (AMM) and Decentralized Exchanges (DEXs).
Nevertheless, it is essential to unravel what AMMs are, how they work, and why they are considered key parts of DeFi. Thus, in the current blog post, we will elaborate on the topic above and its relevance for the sector of decentralized finance.
What are AMMs?
Automated Market Makers are the underlying protocols ran by Decentralized Exchanges that rely on a mathematical formula to establish the price of assets. In traditional exchanges, prices are determined by an order book that matches buy and sell orders, but with AMMs, assets are priced according to a pricing algorithm instead.
Even if somewhat similar, these pricing algorithms may vary slightly between AMMs. The first AMM DEX introduced was Uniswap, which used Vitalik Buterin’s proposed formula of XY=K, where X represents a token within the liquidity pool, Y represents the other, and X*Y must always amount to a fixed constant, K. In simpler terms, this means that if one of the variables changes, the other will change as well, for the total pool liquidity to remain equal.
How do they work?
While traditional exchanges serve as the middleman to enable buyers and sellers to meet at a coinciding price point on a centralized order book, AMMs allow for a different approach. They eliminate the need for a trading counterparty, as trades occur between a user and a smart contract. So, instead of peer-to-peer (P2P), AMMs become peer-to-contract (P2C).
However, AMMs had to provide an alternative solution for market creation and asset liquidity without trading counterparties. That’s when Liquidity Pools and its Liquidity Providers come into play.
Liquidity Pools explained
As the name suggests, Liquidity pools can be viewed as a big pool of funds that users can trade against. Liquidity Providers (LPs) add funds to Liquidity Pools and are rewarded with fees from within the pool. In Uniswap, LPs need to deposit equivalent amounts of two different assets, like $ETH and $UNI, for an ETH/UNI pool.
Because X*Y must always amount to the same value of K, every time users buy the asset X from the pool, it gets more and more expensive. Slippage occurs when the ratio between both assets changes drastically. The more Liquidity a Pool has, the less slippage will occur, making it essential for Liquidity Pools to attract as many LPs as possible.
Advantages and Downsides of AMMs
AMMs are vital for Defi and are proven to work seamlessly with impressive efficiency at times. Nevertheless, there is always a good and a wrong side. Let us start by debating some of the advantages.
- Pure Decentralized Trading: Without the need for any kind of KYC or log in, users can maintain high anonymity and access a world of assets with nothing but a crypto wallet. Thus, taking advantage of platforms that usually have no downtime whatsoever.
- Efficiency and Liquidity: With the evolution of AMMs, protocols are becoming more efficient at reducing slippage and getting better asset prices. While DeFi adoption and usage keep growing, users continuously increase liquidity in AMM exchanges, leading to better rewards.
Downsides of AMMs:
Above, we have slightly mentioned the danger of High Slippage. This keeps on being one of the main concerns regarding AMMs, especially when users set large orders and, even if new algorithms are designed to avoid it, AMMs still depend on pools of combined assets.
The risk of Impermanent Loss is the second major downside of AMMs. It takes place if tokens suffer a change in price ratio after being deposited into a pool. The impermanent loss will be bigger, the bigger the change, and, in this case, users may end up withdrawing a smaller amount of their assets than the initially deposited. The risk of Impermanent Loss can be reduced, however, by pairing assets with similar prices or less volatile, such as stablecoins
Closing Thoughts
Although still in a very early stage, AMMs represent the very heart of DeFi, and the freedom and innovation they brought to the industry are truly tremendous. Whatever limitations they still carry can be expected to be reduced in the upcoming years as protocols keep evolving and more people get involved in developing DeFi tools, which will inevitably lead to better products, smaller fees, and less risk.
About Solanax
Solanax is a Solana-based automated market maker (AMM) exchange providing lightning-fast trades, pooled liquidity, and other income-generating features. Solana was chosen as the underlying blockchain to facilitate low-cost, high-speed transactions. It is a permissionless, high-performance blockchain based on the Proof of History consensus (PoH).
Given the advantages that Solana offers when compared to other blockchain ecosystems, it is a popular solution among investors, users, and developers. Ethereum’s Proof of Work Consensus is slow, hard to scale, and comes with high gas fees which were exacerbated by its account-based system. Where Ethereum has failed to live up to the community expe, Solana quickly proves to be a viable alternative.
Solanax will utilize the cross-bridge Wormhole to connect to projects and digital assets existing on the Ethereum blockchain, facilitating adoption and allowing the crypto community to seamlessly move tokenized assets from one blockchain to another, improving interoperability and liquidity setup.
It is faster and cheaper; Solanax offers on-chain liquidity; traders will have more control over their trading activities; an integration of Wormhole for fusion with tokenized assets on the Ethereum blockchain, and much more.
For more details on the project at the forefront of the DeFi evolution, visit:
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