Automated market makers are one of the most important pieces of a functioning and liquid decentralized exchange.
This article will discuss automated market makers and how they work on decentralized exchanges. We will also explore AMM liquidity pools' role in providing liquidity to these exchanges.
What Are Automated Market Makers
Automated market makers (AMM) are protocols used on decentralized exchanges that utilize a mathematical formula to price an asset like cryptocurrency.
Traditional exchanges use order books to provide prices, whereas AMM's price an asset using an algorithm. The algorithmic formula used will vary depending on the exchange you use.
Traditionally, market makers are firms with plenty of cash and intricate strategies which provide a tight bid-ask spread on an order book exchange.
Automated market makers just decentralize the process to allow trading of any market asset without a counterparty.
But, because this is decentralized, the market still needs liquidity; this comes in the form of AMM liquidity pools.
How Does Automated Market Making Affect Decentralized Exchanges
When trading, you tend to get a trading pair, for example, SOL/BNB; on centralized exchanges, you'd require a counterparty (another trader) to take the opposite side of your trade to provide the liquidity.
With an AMM, you trade with a smart contract which offers the liquidity to make the trade. But, where does the smart contract get the liquidity from? It comes from a liquidity pool. A Basic Understanding of How Liquidity Pools Work
Liquidity pools are great for ensuring constant buyers and sellers of a particular asset such as Parcl assets.
A liquidity pool is a shared pot of coins at its most basic level. Users deposit assets into liquidity pools, and the price of the assets in the pool is set by a mathematical formula.
Liquidity providers are then rewarded for providing liquidity by receiving a reward fee on trades that happen within their liquidity pool.
The process that people participate in to earn passive income from providing liquidity is called Yield Farming. You might be wondering, what if someone makes a large enough trade that there isn't enough liquidity in the pool to facilitate it?
Well, this is a valid problem liquidity pools have, and large orders could face something called slippage, this is when the market doesn't have enough liquidity to fulfill your order at the current price, so it continues to fill until the order is complete, but as the price of the asset fluctuates, the price you pay might be much higher than expected.
Real estate is considered a fairly illiquid market as there's no guarantee of buyers or sellers. Parcl uses AMM liquidity pools to incentivize people to provide liquidity in return for a reward fee. For the first time, we can now consider Real Estate as a liquid market, or at least the way we do it makes it liquid.
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