A Beginner’s Guide to Automated Market Makers (AMMs)

Automated Market Makers (AMMs) have revolutionized decentralized trading, enabling users to swap digital assets in a trustless, permissionless manner without the need for centralized exchanges. Instead of relying on order books or middlemen, AMMs use liquidity pools and smart contracts to facilitate transactions, adjusting prices based on supply and demand. In this article, we’ll explore the fundamentals of AMMs, their benefits, risks, and how they have evolved over time. We'll also take a closer look at the TON Blockchain’s v2 and v3 AMMs and how they empower decentralized finance (DeFi) participants.

What is an Automated Market Maker (AMM)?

An Automated Market Maker is a decentralized trading protocol that uses smart contracts to facilitate token exchanges. Rather than matching buyers with sellers as traditional exchanges do, AMMs use liquidity pools to ensure there’s always liquidity available. Token prices are determined by algorithmic formulas, adjusting dynamically based on supply and demand within the pool.

Key Features of AMMs:

No Order Book Required: AMMs eliminate the need for buyers and sellers to be online at the same time. Trades occur instantly using liquidity pools, allowing for seamless trading.

• Algorithmic Pricing: Prices in AMMs change in real time based on supply and demand, ensuring that tokens are priced efficiently without human intervention.

• Anyone Can Provide Liquidity: Users, known as liquidity providers (LPs), can contribute tokens to a pool and earn a share of the trading fees. This makes AMMs an accessible and decentralized way for users to participate in DeFi.

How Do AMMs Work?

AMMs rely on liquidity pools, which are smart contracts holding two types of tokens. These pools act as markets for specific trading pairs, such as TON/USDT. When a user swaps tokens, the price adjusts automatically according to a predefined formula based on the assets in the pool.

Liquidity Pools:

• Providing Liquidity: Anyone can become an LP by contributing tokens to a pool, helping to maintain liquidity for other users.

• Setting Initial Prices: The first LP in a new pool sets the initial price of tokens. If this price deviates from the global market rate, arbitrage traders may step in to correct it, which could result in impermanent loss for the LP.

• LP Tokens: When you contribute to a liquidity pool, you receive LP tokens. These tokens represent your share of the pool and entitle you to a portion of the trading fees. On platforms like TONCO DEX, 90% of trading fees are distributed to LPs.

Earning with LP Tokens: Once you’ve earned LP tokens, you can burn them to withdraw your liquidity along with any accumulated fees. This process ensures LPs are rewarded for providing liquidity to the market.

What is APR (Annual Percentage Rate)?

APR is the potential annual return an LP can earn by providing liquidity to a pool. It includes trading fees and any platform incentives, and higher trading volumes typically result in higher APRs. AMMs allow users to earn passive income by contributing to liquidity pools.

AMMs on TON: v2 vs. v3 Models

TON Blockchain has integrated AMMs as a crucial part of its DeFi ecosystem. The two primary AMM models in use today are v2 and v3.

v2 AMMs: Traditional Liquidity Distribution

• How They Work: v2 AMMs, such as STON.fi and DeDust.io, use constant product market maker algorithms to ensure that the value of two tokens in a liquidity pool remains balanced (typically a 50/50 split).

• Advantages: These AMMs guarantee liquidity availability, even for large trades.

• Drawbacks: Capital efficiency is low because liquidity is evenly distributed across all price ranges, meaning that a significant portion of liquidity may remain unused.

v3 AMMs: Concentrated Liquidity

v3 AMMs, such as those on TONCO DEX, offer a more efficient use of capital through concentrated liquidity. This model allows LPs to allocate their liquidity within specific price ranges rather than distributing it evenly.

• Focused Liquidity: LPs can choose which price ranges to provide liquidity for, rather than spreading their liquidity across the entire price spectrum.

• Higher Earning Potential: By concentrating liquidity around active trading ranges, LPs can earn more fees on their positions.

• More Active Management: LPs must monitor their positions more closely since liquidity stops earning fees if the price moves outside their chosen range.

TON Blockchain’s v3 AMMs give users the flexibility to choose the liquidity model that best suits their needs, allowing for more tailored and efficient trading strategies.

Risks of AMMs: Understanding Impermanent Loss

While AMMs offer substantial earning potential, there are also risks. One of the biggest challenges for LPs is impermanent loss. This occurs when the price ratio of the tokens in a liquidity pool changes.

• What Is Impermanent Loss?: Impermanent loss refers to the difference in value between holding tokens outside of a pool and holding them within the pool. If one token’s price increases significantly while the other remains the same or decreases, the LP might lose out compared to simply holding the tokens.

For example, if you provide liquidity to a TON/USDT pool when TON is priced at $5, and then TON rises to $10, arbitrage traders will rebalance the pool. This rebalancing may leave you with less TON than you originally provided, even though the pool still holds value.

How to Manage Impermanent Loss:

• Monitor Market Trends: Keep an eye on price movements and adjust your liquidity positions as needed.

• Choose the Right Pool: Select pools with assets that move in tandem, like the stTON/TON pair, to minimize the risk of impermanent loss.

• Use Concentrated Liquidity: v3 AMM models allow LPs to concentrate liquidity in active price ranges, potentially reducing impermanent loss.

The Bottom Line

AMMs have reshaped the world of crypto trading, offering a more decentralized, efficient, and permissionless way to swap assets. By using liquidity pools, LP tokens, and algorithmic pricing, AMMs allow users to participate in DeFi while earning passive income. Whether you prefer the traditional v2 AMM model or the more efficient v3 concentrated liquidity model, AMMs provide a variety of opportunities to contribute to the ecosystem and earn rewards.

As the DeFi space continues to grow, understanding AMMs and their mechanics will be essential for anyone looking to engage in decentralized trading on platforms like TON Blockchain.