One of the great unlocks of blockchain technology is the automated market maker decentralized exchange (AMM DEX). DEXs represent a new paradigm shift in the history of finance in which trading assets can be done permisionlessly. DEXs are also one of the top use cases for LSTs.
An automated market maker (AMM) is a decentralized trading mechanism used to facilitate asset swaps without the need for traditional central order books. Instead of matching with a different user on the opposite side of an intended trade, AMMs allow users to trade with a smart contract to swap in and out of assets. Some of the most popular and widely used products on blockchains today are AMMs, such as Uniswap, Sushiswap, Jupiter, and Pangolin.
How an AMM works
AMMs use liquidity pools, where users deposit pairs of tokens, to provide liquidity for trading. Instead of matching buy and sell orders from different users, AMMs use mathematical formulas to set the price of assets within the pool.
The most common formula, x*y = K, was introduced by Uniswap v1 (link to Uniswap white paper). The x*y = K formula is the core principle behind the functioning of a basic AMM, ensuring that the product of the quantities of two tokens in a liquidity pool remains constant. When a user trades one token for another, the amount of one token (x) increases while the amount of the other token (y) decreases, keeping the product (k) the same. This constant product formula ensures that the prices of the tokens adjust automatically based on supply and demand within the pool. As more of one token is added, its price decreases, while the price of the other token increases proportionally, maintaining the balance dictated by the constant K. Liquidity providers are incentivized with depositing tokens in each pool with rewards paid by the protocol as interest, usually as trading fees or governance tokens of the AMM.
For instance, say a DEX has a liquidity pair of SOL-USDC, and at the time of the pool’s launch, SOL is $100. The formula used is x*y = K. Say the initial pool holds 10 SOL and 1000 USDC, making constant K = 10,000. Now say a user wants to swap .1 SOL for USDC. After depositing her 0.1 SOL, with the constant product of 10,000, she would receive 9.901 USDC and the new price of SOL would be $98.03.
One of the main benefits of an AMM is they require much less social coordination to facilitate trading. AMMs allow for the continuous trading of assets with no intermediaries. This is especially useful for new tokens. Before AMMs, creators of a new asset would have large startup costs in spinning up the liquidity necessary to sustain an orderbook. With AMMs, this overhead is greatly reduced. Asset creators need only create a pool of two assets and users can begin trading.
Liquidity and Risk
AMMs are not without risk, notably, impermanent loss and slippage. Impermanent loss is a phenomenon that occurs when the value of tokens in an Automated Market Maker (AMM) liquidity pool diverges from the value they would have had if they were simply held by the user. The loss is “impermanent” because it only becomes permanent if the liquidity provider withdraws funds while the price difference exists. When users deposit their assets into a liquidity pool, they receive liquidity provider (LP) tokens representing their share of the pool. Again, as the price of the pooled assets changes due to trading activities, the ratio of the assets in the pool adjusts to maintain the constant product formula (x * y = k). Thus, the redemption ratios of LP tokens change as well. If the price of one asset increases or decreases significantly, liquidity providers might find that they have more of the less valuable asset and less of the more valuable one when they withdraw, resulting in a potential loss compared to holding the assets outside the pool.
Crucial to a positive AMM user experience is having deep liquidity in pools. The depth of each liquidity pool determines how efficient the pair is. Ideally, each marginal trade should have little effect on the price of the tokens in the pool. Deep liquidity ensures that trades can be executed with minimal slippage and price impact. Slippage occurs when a trade is large enough relative to the liquidity in the pool that it significantly changes the price of the asset being traded. For illiquid assets, even small trades can have drastic impacts on prices. Deep liquidity is crucial because it allows for more substantial trades without drastically affecting the asset prices. It also attracts more traders and liquidity providers, creating a positive feedback loop that enhances the overall health and usability of the AMM. For decentralized exchanges to compete with traditional ones, ensuring deep liquidity is fundamental, as it directly impacts the user experience and the attractiveness of the platform for high-volume traders and institutional investors.
LSTs and AMMs
Liquidity Staking Tokens (LSTs) are essential liquidity for AMMs, especially for new chains with scarce liquidity early on. LSTs represent staked assets that earn rewards while simultaneously being tradable within DeFi ecosystems. Because they are yield bearing and able to be spun up right away on a new L1, LSTs are great collateral for AMMs. By incorporating LSTs into AMMs, the pools can attract more liquidity from stakers who would otherwise lock their assets in staking contracts without additional utility. This allows for a more significant capital influx into the entirety of a chain’s DeFi. For an AMM, deep liquidity with LST pairs helps in reducing slippage and enhancing the stability of trading pairs. As more assets are staked and converted into LSTs, the potential liquidity in AMMs expands, creating deeper pools that can handle larger trades more efficiently. A new chain may not have much liquidity early on in its lifespan, and LSTs can help alleviate the DeFi cold start problem, giving liquidity to AMMs and allowing users to trade assets.
Conclusion
Kintsu is building the first liquid staking protocol for Monad. New AMMs on Monad will be able to utilize sMONAD for trading pairs across all tokens on the network. As new tokens are created, an abundance of sMONAD liquidity will allow for a great UX as users are able to swap assets cheaply and efficiently.
Follow our social channels to stay up to date on everything Kintsu!
