What if there were an alternative means of asset allocation that smoothly and automatically adjusted pricing in response to demand? What if these price shifts could also be designed to shape and regulate market behavior, to ensure that markets aren’t just orderly, but optimized?
That’s the promise offered by automated market makers, which not only provide continuous, on-demand asset liquidity, but also can be designed to programmatically implement incentives and disincentives for buying, selling, or holding assets. And by using AMMs, marketplace operators can guide market behavior across a full ecosystem, since they can serve as a persistent benchmark for other transaction platforms, establishing a price that other market mechanisms must match or beat.
In the context of blockchain, AMMs are smart contracts that transact digital assets automatically based on predetermined algorithms. They can be used to mint and distribute new assets in exchange for collateral, or they can be used to control the exchange rate between two existing assets — a common use case for AMMs in the world of decentralized finance. In fact, AMM-driven DEXs now own 93% of DEX transaction market share, and AMMs have been a primary engine for the overall growth of DeFi.
AMMs have several built-in advantages that make them a valuable complement to other methods of asset transaction. Perhaps the most basic one is that they provide continuous liquidity: Other mechanisms, such as posted-price sales, order books and auctions, suffer when there are few participants, since it becomes harder and harder to match buyers and sellers at any given price point.
Because AMMs work continuously and react instantly to changes in demand, they serve as an invisible robot hand in the market, pushing it in directions that can advance the specific goals of an asset issuer or marketplace operator.
The power and adaptability of AMMs has made them a pillar of the emerging digital asset economy. But, AMMs are not without limitations and vulnerabilities, and the very things that make them uniquely useful also present unique challenges.
Fortunately — as we’ll explore over the course of this series — there are ways to mitigate many of these concerns, and AMMs are continuing to evolve rapidly as they emerge as one of the most essential tools in blockchain economies.
Want to learn more about AMMs and pricing curves? Read our in-depth article here.