AMM crypto is a fast-growing subsector of DeFi, revealing developers’ desire to build user-centric, privacy-preserving, and highly functional open-source products. The innovative technology aims to provide users with more options to swap trustlessly without privacy intrusion while also earning passive income when choosing to supply liquidity in various pools. As such, the technology has attracted a wide range of investors who are looking for new opportunities to invest in crypto without losing money. However, despite the fact that the innovation is a promising one, it’s not without its risks. Among these include capital inefficiency and impermanent loss, which can be a big hitch for investors who opt to become LPs for AMM-based protocols.
An AMM-powered Decentralized Exchange (DEX) operates as a peer-to-contract platform, where trades happen between users’ wallets instead of an order book. This means that the price you get for an asset you wish to sell or buy on a DEX is determined by a formula, rather than a traditional market order.
As a result, the lack of an order book can lead to price fluctuations and even slippage. To negate these issues, many DEXs rely on AMMs to ensure that the pool ratio of the trading pair remains balanced. Uniswap and 1inch, for example, are some of the most popular examples of DEXs that use this type of algorithm to maintain their pools.
For instance, if there is an imbalance in the ETH/BTC ratio of the pool, the “x*y=k” algorithm can automatically adjust its composition by adding or subtracting tokens to ensure that it always matches the desired ratio. This helps avoid a lot of the pitfalls that would otherwise make it difficult for traders to make profits in a volatile environment.
In addition to preventing price discrepancies, the AMM also incentivizes liquidity providers to keep their tokens deposited in the pool for as long as possible. This is because they can earn transaction fees from the liquidity-taker when he or she extracts funds from the pool.
However, the most significant risk that comes with supplying liquidity to an AMM-powered DEX is the possibility of an impermanent loss. This can occur when the value of your deposited tokens declines after you deposit them in the pool. This is a common concern for LPs and one reason why it’s important to carefully research the projects that you choose to invest in.
Fortunately, this issue is mitigated by the fact that AMMs only lose money if you withdraw your assets from the pool. Hence, pools that contain stablecoins and wrapped tokens as well as token pairs with similar values tend to operate more efficiently than those with larger ratio gaps. In addition, the impermanent loss is usually negligible if you only choose to deposit stablecoins and wrapped tokens in the pool. To further reduce the risk, you can always diversify your token portfolio by supplying liquidity in several different pools at once. This is what is known as yield farming and has been a successful strategy for some of the most active LPs on Uniswap.