To purchase your first bitcoin, you opt to sign up for the drama that is the bitcoin market; you have to deal with pricing volatility, traders blowing up their accounts, exchanges going bust, and everything in between. It truly is the wild west, and It can take a while to understand how everything works in the bitcoin industry. The more you understand, the better the decisions you can make and manage the risk you are taking based on your entry points into bitcoin.
When you exchange fiat money for bitcoin, you generally have two options.
- P2P exchange, where you look for traders selling bitcoin and engage with an individual in a sale.
- Centralised exchange (CEX/VEX), where you purchase from an order book where the exchange or private market makers fill the orders along with individual traders using limit orders.
While these methods cater to most bitcoin transactions, there is another way of matching buyer and seller demand through something known as an Automated Market Maker (AMM).
What is an automated market maker?
Automatic or automated market makers (AMMs) are a type of protocol that use algorithmic “money robots” to make it easy for individual traders to buy and sell digital assets. Instead of trading directly with other people, as with a traditional order book, users trade directly through the AMM.Â
AMMs automate the process of pricing and matching orders on the exchange, typically using an algorithm to source the price from certain centralised exchanges that provide them with data as an oracle.
These oracle data feeds are then used to price the two paired assets, and trades can be made based on the amount of capital committed to the AMM. AMMs effectively manage a pool of capital and try to facilitate trades while clipping a fee for their service.
The fees earned on AMMs are typically paid back to the users who provide capital (Liquidity Providers) as compensation for risking their capital to help facilitate trades.
The permissionless exchange model
These AMM protocols are what form the foundation of what some refer to as DEXs (Decentralised Exchanges) or rather permissionless exchanges. The term DEX is somewhat confusing because it alludes to the idea that no one controls the DEX website or protocol; this is not always true.
While the permissionless exchange is far more accurate since all these services offer, you are the ability to trade without the need for an account or to conduct KYC operations to access their markets.
AMM vs Order Book Model
The main difference between an AMM and an order book model is that an AMM is a liquidity pool that automatically sets prices based on the amount of liquidity within the pool. An order book model facilitates price discovery through buyers and sellers setting their own prices.
When using an AMM, there is no need for manual price setting as the liquidity pool takes care of it automatically through the data it secures from price feeds connecting it to the broader bitcoin market.
With an order book model, the market participants must manually set prices and create orders to buy and sell. Additionally, an AMM typically offers much lower fees and better liquidity than an order book model.
Since AMMs are run by a predefined set of rules and not individual actors placing orders, it tends to come in three main flavours.
Constant Product Market Maker (CPMM)
The first type of CFMM to emerge was the constant product market maker (CPMM). CPMMs are based on the function x*y=k, which establishes a range of prices for two assets according to the available quantities (liquidity) of each token.
When the supply of token X increases, the token supply of Y must decrease, and vice-versa, to maintain the constant product K. When plotted, the result is a hyperbola where liquidity is always available but at increasingly higher prices, which approaches infinity at both ends.
Constant Sum Market Maker (CSMM)
The second type is a constant sum market maker (CSMM), which is ideal for zero-price-impact trades but does not provide infinite liquidity. CSMMs follow the formula x+y=k, which creates a straight line when plotted.
This design, unfortunately, allows arbitrageurs to drain one of the reserves if the off-chain reference price between the tokens is not 1:1.
Such a situation would destroy one side of the liquidity pool, leaving all of the liquidity residing in just one of the assets and therefore leaving no more liquidity for traders.
Because of this risk, CSMM is a model rarely used by AMMs.
Constant Mean Market Maker (CMMM)
The third type is a constant mean market maker (CMMM), which enables the creation of AMMs that can have more than two assets and be weighted outside of the standard 50/50 distribution. In this model, the weighted geometric mean of each reserve remains constant.
For a liquidity pool with three assets, the equation would be the following: (x*y*z)^(â…“)=k. This allows for variable exposure to different assets in the pool and enables swaps between any of the pool’s assets.
The downside of AMMs
As you can tell from the examples above, there are clear flaws in the AMM model that require open market operations, meaning someone has to step in during times of volatility, meaning they cannot be truly decentralised. A lesson many in the digital token space have learned the hard way after platforms like UniSwap popularised AMMs in the altcoin space and attracted investors to become liquidity providers.
Now if you’re not trading and pooling tokens that have no real value and would focus on pairs that have real demand and liquidity like bitcoin and USDT, you’re still not in the clear of risk, remember all investments have risk, so don’t let anyone tell you there is free money to be found in these markets.
Earning fees and impermanent loss
One of the risks associated with liquidity pools is impermanent loss. This occurs when the price ratio of pooled assets fluctuates. An LP will automatically incur losses when the price ratio of the pooled asset deviates from the price at which the funds were deposited.
The higher the shift in price, the higher the loss incurred.
However, this loss is called “impermanent” because there is a probability that the price ratio will revert. The loss only becomes permanent when the LP withdraws the funds before the price ratio reverts.
Low capital efficiency
AMM designs require large amounts of liquidity to achieve the same level of price impact as an order book-based exchange. If there isn’t enough liquidity available to route trades, there would be no interested parties and, thus, no fees earned, meaning you’re putting capital at risk for a meagre return.
AMMs are often seen as “lazy liquidity” that’s underutilised and poorly provisioned. Meanwhile, market makers on order book exchanges can control precisely the price points at which they want to buy and sell tokens. This leads to very high capital efficiency but with the trade-off of requiring active participation and oversight of liquidity provisioning.
AMMs on Bitcoin
Automating market markers is popular on alternative chains due to their ability to create tokens which then require markets with the native asset of their chain. Bitcoin doesn’t have tokens on the base chain; it only has bitcoin as a native asset due to its confirmation times on chain would not be a fitting blockchain to conduct trading between assets on-chain.
However, side-chains like the Liquid Network that do offer token creation through their AMP protocol allow you to create artificial assets on-chain; this could be stablecoins, stocks or debt instruments.
A couple of services have emerged to allow you to pair L-BTC with another Liquid based asset to conduct swaps by committing capital to a Liquidity Pool.
| Service | Website |
|---|---|
| Bitmatrix | https://beta.bitmatrix.app/swap |
| Xdex | https://xdex.ch/ |
Taking a risk on your stack
Hodling has proven to be a tough bar to beat when considering the risk-adjusted returns available to bitcoin holders today. As the bitcoin market matures, we will see services looking to attract liquidity out of cold storage or sitting idly in wallets with the promise of a return.
This could be through attractive premiums to provide routing liquidity on the lightning network, premiums for liquidity to conduct CoinJoins or being a liquidity pool provider for automated market making. Each need for liquidity will carry its own risk and will be priced and repriced according to demand for the service by the broader market.
Again, leaving the safety of bitcoin storage to try and net a yield is not a guarantee and should be handled with caution, even if you’re not handing over custody of funds and using on-chain services.
If you’re feeling a little risky and want to place some bets on market moves, or hedge your bitcoin cold storage with some working capital, then looking at supplying market makers can help you do just that.
