Instead of using dedicated market makers, anyone can provide liquidity to these pools by depositing both assets represented in the pool. For example, if you wanted to become a liquidity provider for an ETH/USDT pool, you’d need to deposit a certain predetermined ratio of ETHTo make sure the ratio of assets in liquidity pools remains as balanced as possible and to eliminate discrepancies in the pricing of pooled assets, AMMs use preset mathematical equations.
To understand how this works, let us use an ETH/USDT liquidity pool as a case study. When ETH is purchased by traders, they add USDT to the pool and remove ETH from it. This causes the amount of ETH in the pool to fall, which, in turn, causes the price of ETH to increase in order to fulfill the balancing effect of x*y=k. In contrast, because more USDT has been added to the pool, the price of USDT decreases.
This means ETH would be trading at a discount in the pool, creating an arbitrage opportunity. Arbitrage trading is the strategy of finding differences between the price of an asset on multiple exchanges, buying it on the platform where it’s slightly cheaper and selling it on the platform where it’s slightly higher.
For AMMs, arbitrage traders are financially incentivized to find assets that are trading at discounts in liquidity pools and buy them up until the asset’s price returns in line with its market price.For instance, if the price of ETH in a liquidity pool is down, compared to its exchange rate on other markets, arbitrage traders can take advantage by buying the ETH in the pool at a lower rate and selling it at a higher price on external exchanges.
In addition to decentralizing exchanges, AMMs allow for market makers (or liquidity providers) who provide capital into the pool and can earn a fraction of transaction fees.
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