MAIN ACTORS AND ASSETS OF AN AMM PROTOCOL
AMMs-based DEXs’ main components.
1.1 Liquidity provider (LP). A liquidity pool can be deployed through a smart contract with some initial supply of crypto assets by the first LP. Other LPs can subsequently increase the pool’s reserve by adding more of the type of assets that are contained in the pool. In turn, they receive pool shares proportionate to their liquidity contribution as a fraction of the entire pool. LPs earn transaction fees paid by exchange users. While sometimes subject to a withdrawal penalty, LPs can freely remove funds from the pool.
1.2 Trader. A trader submits an exchange order to a liquidity pool by specifying the input and output asset and the quantity; the smart contract automatically calculates the exchange rate based on the conservation function as well as the transaction fee and executes the exchange order accordingly.
1.3 Protocol foundation. A protocol foundation consists of protocol founders, designers, and developers responsible for architecting and improving the protocol.
- The development activities are often funded directly or indirectly through accrued earnings such that the foundation members are financially incentivized to build a user-friendly protocol that can attract high trading volume.
Several distinct types of assets are used in AMM protocols for operations and governance.
2.1 Risk assets. Characterized by illiquidity, risk assets are the primary type of assets AMM. Like centralized exchanges, an AMM-based DEX can facilitate an initial exchange offering (IEO) to launch a new token through liquidity pool creation, a capital raising activity termed “initial DEX offering (IDO).
To be eligible for an IDO, a risk asset sometimes needs to be whitelisted, and must be compatible with the protocol’s technical requirements (e.g. ERC20 for most AMMs on Ethereum).
2.2 Base assets. Some protocols require a trading pair always to consist of a risk asset and a designated base asset.
- In the case of Bancor, every risk asset is paired with BNT, the protocol’s native token.
- Uniswap V1 required every pool to be initiated with a risk asset paired with ETH.
- Many protocols, such as Balancer and Curve, can connect two or more risk assets directly in liquidity pools without a designated base asset.
2.3 Pool shares. Also known as “liquidity shares” and “LP shares”, pool shares represent ownership in the portfolio of assets within a pool, and are distributed to LPs.
2.4 Protocol tokens. Protocol tokens are used to represent voting rights on protocol governance matters and are thus also defined “governance tokens”. Protocol tokens are typically valuable assets that are tradeable outside of the AMM (for instance UNI token) and can incentivize participation when e.g. rewarded to LPs proportionate to their liquidity supply.
We have talked a lot about DeFi's features and the on-chain financial services it offers.
The question still remains: how does the fundamental dynamics of an AMM work?
Find out in the next lesson!