Welcome to PYMNTS’ series on decentralized finance, or DeFi.
In these articles, we’ll look at every part of DeFi – the biggest, hottest, most rewarding, and riskiest part of the blockchain revolution. At the end, you will 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 best DeFi platforms?
See part 3: What is a smart contract?
See part 4: What are Yield Farming and Liquidity Mining?
See part 5: What is staking?
See part 6: What are the top 10 uses of DeFi?
See part 7: DeFi and DAO unboxing
See part 8: The very real risks of DeFi
See part 9: What are the best 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 explained what DeFi is and how it is 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 Automated Market Maker, or AMM.
Let’s start with a traditional market maker, which is basically a wholesaler who keeps the market running smoothly by providing liquidity. The market maker is usually a major bank or financial institution that guarantees to buy securities (offer) at one specified price and sell them (ask) at another price, so that a seller does not have to actively seek out a buyer who wants a specific amount of a specific stock at a specific price. Market makers make a profit on the bid-ask spread.
This is a proven system used in many exchanges. It is also a financial intermediary, something crypto in general and DeFi in particular abhorred. Getting rid of them was, after all, the main goal of Bitcoin’s creator.
Without any centralized management – at least in theory – decentralized exchanges (DEXs), in particular, have no place for traditional market makers.
While a DEX could automate the process of direct buyer and seller matching, it would have the same problem: by excluding major cryptocurrencies like bitcoin, ether from Ethereum and a few others, there would have a significant liquidity problem in most thousands and thousands of cryptocurrencies. .
So how do you go about decentralizing a centralized, cash-intensive function? You crowdsource it.
Major DeFi exchanges like Uniswap, SushiSwap, PancakeSwap, Curve Finance, and Balancer all use AMM smart contracts, running a combined trade volume of billions of dollars daily.
The mechanism used by AMMs is the liquidity pool, which offers anyone with cryptocurrencies to invest a return based on transaction fees, and possibly a reward in the form of the pool’s own tokens – this is where liquidity mining comes into play.
See also: PYMNTS DeFi Series: What is Yield Farming and Liquidity Mining?
Liquidity providers lock their crypto – 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 tokens.
They are governance tokens with a vote within the Decentralized Autonomous Organization (DAO) that manages to coalesce on issues such as withdrawal requirements for crypto locked in pools and size of fees charged.
Pools often compete with each other based on the size of the fees, the amount of liquidity, and the trading volume of the tokens in question. They are, of course, prone to hacks and cheats, just like DEXs and centralized crypto exchanges.
It is not so simple. DEX liquidity pools can handle specific trading pairs – for example, ETH and stablecoin USD Coin like ETH/USDC – or, in some cases, the largest pools have several different cryptocurrencies.
Let’s say Ether is priced at $3,500 and USDC is at $1. If you stake one ETH, you will get 3,500 USDC – less trading fees. These fees accrue to pool members based on their percentage of total pool funds.
There is a big “but” at this point – a slippage.
When the trader accepts the swap, it is not when the trade is completed being written to the blockchain. On Ethereum, the blocking time is usually 12-15 seconds, which means that the price of highly volatile cryptocurrencies has time to change between demand or offer and the current transaction.
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 much faster block times, slippage may 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 intermediaries, no managers to pay, and with increasing liquidity and declining slide, AMM-powered DeFi exchanges may have a bright future.