A definition often washes over a reader, leaving the reader influenced, but without any obvious new insight as to the intended meaning or implications of a word. Worse, without proper guidance, a reader may interpret a definition differently than what is intended by the author, or in the case of economics, different from how the discipline is actually employing the definition. Definitions are, however, important, potentially very important. A definition has the potential to provide clarity. At their best, definitions act like a compass, providing a lost reader with several potential directions from which to proceed.
Web1: Static Websites (one-way publishing)
Web2: Platform / Apps (Two-way interactions)
Web3: TokenSystems (Complex Economies)
Web2: Read & Write
Web3: Read, Write & Own
AIRDROP - a technique in which crypto projects send tokens directly to their users' wallets to increase awareness and adoption.
ALPHA - valuable information, usually regarding the value of digital assets like crypto and NFTs before they hit mainstream.
ALTS - short for Altcoins
APEING IN - buying into an NFT project, perhaps without due diligence. This is sometimes a reaction to hype and FOMO.
ATH - All-Time High - the highest price an asset has ever had.
ATL - All-Time Low - the lowest price an asset has ever had.
BEAR MARKET - a period of decline in a financial market.
BEARISH - holding a pessimistic view of a market or asset’s value
BITCOIN - the first decentralized, peer-to-peer digital currency, created by the pseudonymous Satoshi Nakamoto in 2009.
BLOCK - a batch of transactions written to the blockchain. Every block contains information about the previous block
BLOCKCHAIN - Cryptographicaaly secured Block (transactions). Blockchains are the core technology on which cryptocurrency protocols like Bitcoin and Ethereum are built.
BLOCK EXPLORER - a tool for browsing information on a blockchain like transactions, wallets, etc
buy the f*cking dip. When prices are dropping, that's the time to buy.
means “build" - as building or focus in building stuff.
BULL MARKET - a period where market prices are rising.
BULLISH - refers to holding an optimistic view that a market or asset will rise in price.
BURN - process of removing crypto or NFTs from circulation, most of the times by sending them to another wallet.
CENTRALIZED - a hierarchical structure in which authority and control are concentrated within a small group of decision-makers.
CEX - Centralized Exchange - a cryptocurrency exchange managed by a centralized business or entity. E.g.:
CeFi - Centralized Finance - centralized businesses that participate in crypto. E.g.:
COIN - a cryptocurrency built on its own native blockchain, intended to be used as a store of value and medium of exchange within that ecosystem. E.g.:
COLLATERAL - any asset accepted as security for a loan, such as physical assets like real estate or digital assets like NFTs.
COLD WALLET - an offline hardware device used to store cryptocurrencies. E.g.:
CONSENSUS - the state of agreement amongst the nodes on a blockchain.
CONSENSUS MECHANISMS - a process through which nodes on a blockchain agree on a transaction or state of the network.
CRYPTO - short word for cryptocurrency.
CRYPTOCURRENCY - fungible digital assets designed to be used as a medium of exchange.
DAO - Decentralized Autonomous Organization - an organization based on open-source code governed by its users.
DAAP - Decentralized Application - an application built on open-source code that lives on the blockchain.
DD - Due Diligence - making your crypto research or NFT before you invest.
DYOR - short for "Do Your Own Research"
DEGEN - initially short for “degenerate gambler.” Degens are proud people who enjoy ridiculous call options and occasionally aping into shitcoins.
DeFi - Decentralized Finance - the ecosystem of borderless, trustless, peer-to-peer financial tools built on public blockchains.
DEX - Decentralized Exchange - a peer-to-peer cryptocurrency exchange built on the blockchain. E.g.:
DIAMOND HANDS - Someone who holds to crypto or NFT even if it tanks.
DIFFICULTY - the level of computing power needed to verify transactions and mine blocks on a proof-of-work blockchain.
DIFFICULTY BOMB - the process of increasing the difficulty of a proof-of-work blockchain.
EIP - Ethereum Improvement Proposal - a standard format for presenting a new feature or process to the Ethereum community.
ERC - Ethereum Request for Comments - the standard smart contract outline on which Ethereum-based smart contracts are built.
ERC-20 - the Ethereum token standard, providing a standardized smart contract structure for fungible tokens. E.g.: behind most Coins
ERC-721 - an Ethereum token standard that allows for forming unique tokens, otherwise known as NFTs.
ERC-721-A - and Ethereum token standard allows the formation of unique tokens with a lower gas expense. E.g.: the contract the @AzukiOfficial used for their NFTs
ERC-1155 - an Ethereum token standard which allows for fungible, non-fungible, and semi-fungible tokens to be managed by a single smart contract simultaneously. Mostly used in gaming, membership-passes, etc.
ETHEREUM - a public blockchain serving as the foundation for decentralized applications.
FEW - short for “Few understand.” A rallying cry that crypto folks are still early in this space.
FIAT - a currency established as legal tenders, like the US Dollar.
FLIPPENING - a reference to the possible event of Ethereum becoming more valuable than Bitcoin, in terms of market cap.
FLIPPING - a reference to people who like to buy and sell NFTs to profit from small trades.
FOMO - Fear Of Missing Out - a feeling of anxiety, stemming from missing out on an opportunity.
FREN - short for "friend."
FORK - a change to a blockchain protocol. It can be a "hard fork" or a "soft fork" - to be explained later.
FRACTIONALIZE - locking an NFT into a smart contract and then dividing it into smaller parts issued as fungible tokens.
FUD - Fear, Uncertainty, and Doubt - news around an asset that seems negative but turns out to be false or blown out of proportion.
FLOOR - the lowest price available for an NFT in a collection, the minimum amount you need to buy into a collection.
FULL NODE - a blockchain node that stores the blockchain’s complete history and verifies and relays transactions.
FUNGIBLE - an asset that is interchangeable; exchangeable with something else of the same kind. E.g.: BTC or ETH
GAS - a fee paid by a user to conduct a transaction or execute a smart contract on the Ethereum blockchain.
GENESIS BLOCK - the very first block of a blockchain network.
GENESIS COLLECTION - the very first NFT collection of an NFT project.
GM - short for "good morning."
GN - short for "good night."
GMI - short for “gonna make it.”
GWEI - a denomination of ether used as the unit of measure for Ethereum gas prices. 10^9 gwei = 1 ether.
HARD FORK - a fundamental change to a blockchain incompatible with the existing protocol, requiring the formation of a new chain. E.g., Ethereum Classic vs Ethereum
HASHING - the process of taking an input of any size and producing a corresponding fingerprint of a fixed length.
HASH RATE - hash power - is the rate at which a computer can generate guesses to a cryptographic puzzle.
HFSP - Have Fun Staying Poor - a phrase commonly aimed at individuals who do not own any cryptocurrencies or don’t believe in the value of a certain asset.
HODL - an expression meaning “hold” and frequently taken to be an acronym for Hold On for Dear Life.
HOLDING THE BAG - an unfortunate position you find yourself in when an asset you own drops in value quickly, but you do not sell.
HOT WALLET - is an online address where you save your assets. E.g.:
ICO - Initial Coin Offering - selling tokens to the public to raise capital for a crypto-based project. The equivalent of an IPO.
IRL - In Real Life - speaks to events or activities that happen offline
IMMUTABLE - data cannot be changed or modified by anyone after its creation. The core defining feature of blockchain technology.
INTEROPERABILITY - the ability to see and share information across multiple blockchains. Also known as "cross-chain", allowed by "bridges".
IEO - Initial Exchange Offering - similar to an initial coin offering, or ICO, an initial exchange offering is a method of selling tokens to raise capital, but with increased regulation.
KEY - the public or private key of a wallet
L1 - Layer 1 - blockchain platform itself, also referred to as the base layer, mainchain, or mainnet. E.g.:
L2 - Layer 2 - protocols, built on top of a Layer 1 blockchain and used to improve scalability and privacy and add cross-chain communication.
LAMBO - short for Lamborghini. The ability to purchase Lambo is a goalpost for success.
LIGHT NODE - a blockchain node that downloads just enough data from the blockchain to process and verify transactions.
LIQUIDITY - a measure of how easily an asset can be bought, sold, or traded in a given market or on an exchange.
LIQUIDITY POOL - a collection of user-provided funds locked into a smart contract to facilitate trading on a DeFi platform.
MAINNET - short for "main network", this is a main Layer 1 blockchain, as opposed to a Testnet or Layer 2 solution.
MARKET CAP - the total value of an asset based on its current market price.
MASTER NODE - a blockchain node that verifies and relays transactions, stores the blockchain’s complete history, and may participate in voting, governance, etc.
METAVERSE - a theoretical emergent networked online space with digitally persistent environments that people inhabit as avatars.
MAXI - Maximalists - people who believe that one particular crypto is the only viable by far and predominantly invest in it.
MINING - in a Proof of Work system, this is the process of verifying transactions, organizing them into blocks, and then adding blocks to the blockchain.
MINERS - people who work in a Proof of Work system to validate blocks.
MINTING - validating information, such as domain ownership, and registering that onto the blockchain.
MINT - when someone buys an NFT for the first time, creating it for the first time in the blockchain.
MOON / TO THE MOON - this phrase implies that the value of an asset will go so high that it will reach the literal moon.
MOONBOY - “financial experts” and YouTubers who are optimistic and constantly explaining how a given asset is “about to go to the moon!”
NFT - Non-fungible tokens - unique digital assets that prove authenticity and verify ownership.
NFT DOMAINS - domain names minted on the blockchain which allow people to govern their own data, set their Web3 username, etc.
NGMI - short for “not gonna make it.”
NOCOINER - a term used to describe someone who does not hold any cryptocurrencies or is generally unfamiliar with crypto.
NODE - any device connected to a blockchain network.
NON-FUNGIBLE - something unique, not interchangeable.
ORACLE - a service supplying smart contracts with data from the outside world. E.g.:
P2P - Peer-to-Peer - a distributed network of two or more computers interacting directly without a central server or entity. E.g.: Blockchain
PAPER HANDS - a term used to describe someone who sold a cryptocurrency or stock whose price was falling, usually for a loss.
PFP - profile picture, usually referring to one of an NFT.
PERMISSIONLESS - a system where no entity can regulate who can use it and how - like blockchain.
PILLED - someone that now sees the truth - the underlying opportunities behind the blockchain and Web3.
PRIVATE KEY - an alphanumeric passcode required to withdraw assets from a blockchain wallet and authorize digital transactions.
POS - PROOF OF STAKE - a consensus mechanism that requires nodes, called validators, to stake a set amount of cryptocurrency on the blockchain to verify transactions and mint blocks.
POW - PROOF OF WORK - a consensus mechanism that requires miners to complete complex mathematical puzzles to verify transactions and mint blocks.
PROTOCOL - the foundational software layer of a program.
PUBLIC KEY - used to point to your wallet address. Alphanumeric code serves as the address for a blockchain wallet.
PUMP AND DUMP - a scheme where a cryptocurrency or other asset is hyped up, leading many to buy into it, raising its price.
PROBABLY NOTHING - often used sarcastically to mean the opposite. It probably is something.
RED PILLED - someone that prefers the truth and understands how blockchain is already the present.
REKT - as in “wrecked,” used to express someone who has suffered a huge loss.
RUG PULL - a scam maneuver where a crypto project takes the funds invested into its protocol or NFT project and runs with it.
ROLLUP - a scaling solution that aims to improve transaction throughput and decrease fees.
RUGGED - someone that has suffered from a Rug Pull.
SATS - the smallest denomination of BTC, equal to 0.00000001 bitcoin.
SCALABILITY - a protocol’s capacity to handle higher demand and increase transaction throughput as the network grows.
SEED PHRASE - a string of words used as a master password to access a crypto wallet.
SELF CUSTODY - having your assets in a wallet not held by an exchange.
SOCIAL TOKEN - a type of token issued with a social purpose like being part of a community or influencer's community.
SER - short for "sir".
SHA-256 - SHA stands for Secure Hashing Algorithm, a set of cryptographic hashing functions designed by the NSA.
STAKING - putting your tokens in to serve as a validator to the blockchain and be compensated accordingly.
SHARDING - a method of separating a network’s nodes into smaller groups (shards) to increase scalability.
SHILL - the act of heavily promoting a cryptocurrency, stock, or other assets to increase adoption and, in turn, raises its price.
SHITCOIN - a cryptocurrency with weak fundamentals and little to no use case.
SIDECHAIN - a parallel blockchain used to offload transactions from the main chain in order to increase scalability or add other functionality. E.g.:
@0xPolygon / Litecoin
SLASHING - the process of burning or redistributing a validator’s staked cryptocurrency as punishment for approving fraudulent charges or otherwise endangering the network.
SWEEP THE FLOOR - buying NFTs in bulk at the floor price to secure the floor.
SLIPPAGE - Slippage is the difference between a cryptocurrency’s quoted price and the price that the trade executes.
SMART CONTRACT - self-executing code deployed on a blockchain. Allow transactions without intermediaries.
SOFT FORK - a backward compatible update to a blockchain.
SOLIDITY - the native programming language of Ethereum, mainly used to write smart contracts.
STABLECOIN - a token with its value pegged to another asset. E.g.: USDC is pegged to the US Dollar.
TESTNET - a software environment that mimics a mainnet blockchain.
TOKEN - unlike a coin, a token is a digital asset created on an existing blockchain.
TPS - Transactions per second - the number of transactions a blockchain can handle per second.
TRANSACTION - data written to a blockchain.
TVL- Total Value Locked - the measure of the assets locked into a dapp’s smart contract usually expressed in USD.
TXN HASH - short for transaction hash, or transaction ID. unique identifier used to represent a specific transaction, written as a long string of letters and numbers.
UP ONLY - implies that a cryptocurrency or other asset can only increase in value.
VAPORWARE - a project that is announced and marketed but never actually materializes - it "evaporates."
WAGMI - "We're All Gonna Make It"
WALLET - a software application or hardware device that stores the private keys to blockchain assets and accounts. E.g.:
WALLET ADDRESS - known as public key, it's an alphanumeric code that serves as the address for a blockchain wallet, similar to a bank account number.
WEI - the smallest denomination of ether, named after cypherpunk and cryptocurrency pioneer Wei Dai - 10^18 gwei = 1 ether.
WHITELIST - list of addresses allowed to mint an NFT Collection.
WEN - short for "when"
WHALE - individuals, institutions or exchanges that hold significant amounts of tokens of a particular cryptocurrency
YOLO - You Only Live Once - investing too much money into a single asset; making a generally risky bet.
A liquidity pool holds cryptocurrencies or tokens such as Bitcoin, Ethereum, USDC, etc. In an AMM, users trade with the liquidity pool by sending and receiving tokens.
Liquidity providers are users who put tokens in a liquidity pool on an AMM protocol. In exchange, they receive pool tokens which represent partial ownership of the pool's assets.
Traders are users who want to exchange tokens they own for another type of token. They can do this on an AMM through a Liquidity Pool that contains both types of tokens. A trader will send one type of token to a Liquidity Pool, and receive a different type of token from the Pool.
An arbitrageur is a particular type of trader. Arbitrageurs profit from price mismatches across different markets, by buying a token at a cheaper price on one market and selling it at a higher price on another market.
Arbitrageurs play a crucial role in AMMs, since their trades drive the token price towards their true market value.
Risk assets refer to the assets that are traded through the AMM (e.g. ETH, DOT, BTC in any DEX) These are typically assets that originate outside the protocol, which liquidity providers bring in to pools.
Base assets are a type of standard token that a protocol may require in all of its pools. Not all protocols use base assets, but some do.
For instance, Bancor is a decentralized exchange with an AMM that uses its own native Bancor Network Token (BNT) token as the base asset.
This makes it so the Liquidity Provider only needs to contribute the risk asset, while also strengthening the value of the BNT token . Uniswap V1instead used ETH as the base asset for its pools. In the next version of Uniswap, it was possible for pools to contain two ERC20 tokens without using ETH as a base asset.
Pool shares are also known as pool tokens, LP token, LP shares, etc.
These shares are minted (created) to the Liquidity Provider based on the fraction of the total pool assets which the LP has provided.
Pool shares serve as proof of ownership of a portion of the pool.
These shares also represent the amount of the fee revenues for which the LP is eligible. At any point in time, the LP can decide burn (destroy) their pool shares to withdraw their liquidity from the pool.
Finally, the protocol tokens or governance tokens represent voting rights and serve as a democratic instrument in the system.
These tokens provide a governance structure where participants may be involved in decision making about aspects of a cryptoeconomic system.
Governance tokens can have an economic value themselves and are often traded on markets, which makes them attractive and further encourages participation in the ecosystem.
Automated Market Makers attract users by offering rewards and incentives.
Liquidity rewards are assigned to LPs for locking up their funds in a pool. The most common type of liquidity rewards are pool fees and interest from staking.
The pool shares that an LP owns entitle the LP to a percentage of the pool’s trading fees, proportional to the percentage of shares the LP owns.
In addition, some AMMs offer the option for users to stake their funds, earning interest on the tokens provided as time goes on. The idea of staking is similar to a savings account or certificate of deposit in a traditional bank - interest is earned in exchange for keeping funds in the pool for a certain period of time.
Another potential reward for Liquidity Providers consists of protocol tokens (or governance tokens) representing governance power and allow liquidity providers to participate in decision making, e.g. by voting on issues related to the protocol.
Security rewards are given to those who help maintain security in a network. Many protocols offer monetary rewards for services such as writing needed code or finding bugs in the system. A “bug bounty” program allows users to report potential security issues, in the hopes hat the resulting money and reputation will sufficiently incentivize people to report the vulnerability rather than exploit it for their own profit.
There are both implicit and explicit costs for interacting with an AMM.
Explicit costs are designed to be part of the system.
Implicit costs emerge through market activities.
Liquidity Withdrawal Penalty, Swap Fee, & Gas Fee
Liquidity withdrawal penalties are used to discourage people from withdrawing their assets,since such withdrawals negatively impact the system.
While such a penalty discourages exit, it could also create a barrier for entry as a Liquidity Provider may not know when they will need to withdraw their assets.
A swap fee is charged to an individual trader on each exchange they make in the liquidity pool. This serves as compensation for those who have provided liquidity.
Gas fees are the reward given to nodes for validating transactions on the blockchain.
The gas fee can vary considerably, since it is determined by the supply and demand for verifications. A wise trader considers the gas fee before implementing a trade.
Slippage, Impermanent Loss, & Security Risks
Slippage refers to the difference between a trader's requested price and the actual price at which the trade is executed. Slippage occurs due to the actual mechanics of AMMs, which we will discuss in detail later.
For now, here are a few important facts to know about slippage:
Traders prefer to have less of it.
Smaller pools will have more of it.
Smaller trades will have less of it.
One cost that often surprises liquidity providers is known as impermanent loss or divergent loss.
Impermanent loss is the difference between the amount a Liquidity Provider earns from providing liquidity to a pool, versus to what the value of the same assets would have been if simply kept in their wallet.
Like anything else on the Internet, there exists a possibility that data will be hacked, breached, or compromised. Unlike traditional banks, users of Automatic Market Makers may not be able to receive compensation for funds lost due to security issues.
Although the loss of funds due to a hack typically occurs in one large event rather than on each trade, it is still a potential cost that users need to take into account.
The first step in the token engineering process is the discovery phase.
When a client comes to a Token Engineer with an idea, there are seven steps for translating the client's vision into a workable form.
Instead of a traditional market of producers and customers, automated market makers (AMMs) employ liquidity pools to allow digital assets to be transferred without consent and automatically. On a conventional trading platform, buyers and sellers propose multiple prices for an asset. When other users find a listed price acceptable, they trade it, and that price becomes the asset’s market price. Stocks, gold, real estate, and a variety of other assets are traded using this traditional market structure. AMMs, on the other hand, employ a different trading method.
AMM is the foundation protocol for autonomous trading mechanisms on decentralized exchanges. This reduces the need for centralized authority like exchanges and other financial institutions. Simply put, it allows two users to swap assets without the need for a third party to facilitate the transaction.
Market makers essentially supply liquidity. Liquidity in trade refers to the ease with which an item may be acquired or sold. Let us provide an example to better grasp this. Let’s say trader A wants to purchase one bitcoin. The centralized exchange that handles the sale has an automated mechanism that finds a seller, trader B, ready to sell a bitcoin at the rate given by trader A. The exchange is operating as a middleman in this case.
In the FIAT world,
As a market maker, Citadel Securities facilitates trading by stepping in as a buyer or seller, earning tiny profits on price differences often within milliseconds
Automated market makers are part of decentralized exchanges (DEXs), which were created to eliminate the need for any middlemen in the trade of crypto assets. AMM may be thought of as computer software that automates the provision of liquidity. These protocols use smart contracts, which are self-executing computer programs that mathematically set the price of crypto tokens and offer liquidity.
Citadel Securities is a leading market maker to the world’s institutions and broker-dealer firms. Our automated equities platform trades over 20% of U.S. equities volume1 across more than 11,000 U.S.-listed securities and trades over 16,000 OTC securities. We execute approximately 35% of all U.S.-listed retail volume, making us the industry’s top wholesale market maker2.
Citadel Securities acts as a specialist or market maker in more than 4,000 U.S. listed-options names, representing 99% of traded volume3, and ranks as a top liquidity provider on the major U.S. options exchanges.
The operation of AMMs next crucial part is a guide on automated market makers described adequately. Before learning how AMMs function, you need to be aware of two key features.
Individual ‘liquidity pools’ with AMMs include the trading pairings that would ordinarily be found on a centralized exchange.
Furthermore, by depositing assets represented in the pool, any individual might supply liquidity to the separate pools. To become a liquidity provider, for example, you must deposit a particular amount of ETH and USDT in an ETH/USDT pool.
AMM assists in the establishment of a liquidity system to which anybody may contribute. This eliminates the need for a middleman, cutting transaction costs for investors. High liquidity is necessary for a healthy trading environment. Slippage might occur if there is insufficient liquidity. Low liquidity leads to excessive volatility in the market’s asset values. AMMs also allow anybody to become a liquidity provider, which comes with perks. Liquidity providers are paid a small percentage of the fees collected on transactions conducted through the pool.
Three AMM models have emerged as the most popular:
Instead of using an order book like a traditional exchange, assets are priced according to a pricing algorithm.
This formula can vary with each protocol. For example, Uniswap uses x * y = k, where x is the amount of one token in the liquidity pool, and y is the amount of the other. In this formula, k is a fixed constant, meaning the pool’s total liquidity always has to remain the same. Other AMMs will use other formulas for the specific use cases they target. The similarity between all of them, however, is that they determine the prices algorithmically.
To make a deal in the AMM protocol, you don’t require another trader. Instead, you may use a smart contract to exchange. As a result, trades are peer-to-contract rather than peer-to-peer.
You’ll need to locate an independent ETH/USDT liquidity pool if you wish to exchange one crypto asset for another, such as Ether (Ethereum’s native currency) for Tether (Ethereum token tied to the US dollar).
As previously stated, a mathematical formula determines the price you receive for an item you wish to purchase or sell. Anyone can become a liquidity provider in AMM if they fulfill the smart contract’s conditions.
As a result, in this case, the liquidity provider will need to deposit a set number of Ether and Tether tokens into the ETH/USDT liquidity pool. Liquidity providers can receive fees on trades in their pool in exchange for providing liquidity to the protocol.
To build a fluid trading system, centralized exchanges rely on skilled traders or financial institutions to provide liquidity for trading pairs. These corporations place several bid-ask orders to mimic the requests of regular traders. This helps the exchange to ensure that counterparties are available at all times for all transactions. In this structure, liquidity providers take on the role of market makers. In other words, market-making encompasses the operations required to provide liquidity for trading pairs.
AMMs provide benefits that enable the introduction of various Defi capabilities that standard exchanges cannot match. Here are a few of their perks:
Decentralization– Smart contracts are established agreements that work by executing orders autonomously. DEXs, when combined with governance structures, effectively shift platform and asset ownership to users. There is no centralized entity.
Non-custodial– Traders and liquidity providers use their crypto wallets to engage with DEXs, keeping full custody of their assets. Smart contracts are then used to specify and handle all transactions.
No manipulation– CEXs are notorious for market manipulation and insider trading. DEXs certainly have no method of influencing pricing in their favour because no one benefits from such acts.
Security– To avoid assaults, DEXs are frequently hosted in a distributed fashion. Furthermore, hackers can only engage with liquidity pools on a trading platform, not with the exchange’s users.
Token-based access– Because of its decentralized nature, anybody may publish an asset on a DEX without relying on the platform’s owners’ vouching or verification mechanism.
An AMM works similarly to an order book exchange in that there are trading pairs – for example, ETH/DAI. However, you don’t need to have a counterparty (another trader) on the other side to make a trade. Instead, you interact with a smart contract that “makes” the market for you.
On a decentralized exchange like Binance DEX, trades happen directly between user wallets. If you sell BNB for BUSD on Binance DEX, there’s someone else on the other side of the trade buying BNB with their BUSD. We can call this a peer-to-peer (P2P) transaction.
In contrast, you could think of AMMs as peer-to-contract (P2C). There’s no need for counterparties in the traditional sense, as trades happen between users and contracts. Since there’s no order book, there are also no order types on an AMM. What price you get for an asset you want to buy or sell is determined by a formula instead. Although it’s worth noting that some future AMM designs may counteract this limitation.
So there’s no need for counterparties, but someone still has to create the market, right? Correct. The liquidity in the smart contract still has to be provided by users called liquidity providers (LPs).
Liquidity providers (LPs) add funds to liquidity pools. You could think of a liquidity pool as a big pile of funds that traders can trade against. In return for providing liquidity to the protocol, LPs earn fees from the trades that happen in their pool. In the case of Uniswap, LPs deposit an equivalent value of two tokens – for example, 50% ETH and 50% DAI to the ETH/DAI pool.
Hang on, so anyone can become a market maker? Indeed! It’s quite easy to add funds to a liquidity pool. The rewards are determined by the protocol. For example, Uniswap v2 charges traders 0.3% that goes directly to LPs. Other platforms or forks may charge less to attract more liquidity providers to their pool.
Why is attracting liquidity important? Due to the way AMMs work, the more liquidity there is in the pool, the less slippage large orders may incur. That, in turn, may attract more volume to the platform, and so on.
The slippage issues will vary with different AMM designs, but it’s definitely something to keep in mind. Remember, pricing is determined by an algorithm. In a simplified way, it’s determined by how much the ratio between the tokens in the liquidity pool changes after a trade. If the ratio changes by a wide margin, there’s going to be a large amount of slippage.
To take this a bit further, let’s say you wanted to buy all the ETH in the ETH/DAI pool on Uniswap. Well, you couldn’t! You’d have to pay an exponentially higher and higher premium for each additional ether, but still never could buy all of it from the pool. Why? It’s because of the formula x * y = k. If either x or y is zero, meaning there is zero ETH or DAI in the pool, the equation doesn’t make sense anymore.
But this isn’t the complete story about AMMs and liquidity pools. You’ll need to keep in mind something else when providing liquidity to AMMs – impermanent loss.