A centralised cryptocurrency exchange will try and create efficient markets for coins and tokens by acquiring customers to generate liquidity. They might do this through a mixture of marketing and product features:
- Offering the widest range of tradeable pairs
- Competitive fees charged per transaction
- Promoting its credibility & regulated status
- Making depositing/withdrawing fiat (on-off ramps) as easy as possible
- Using a native token to discount trading fees
But the main mechanism that centralised exchanges employ to generate liquidity is through external market makers. These are B2B financial services that are paid to artificially generate trading demand for a specific coin, generally ones that are newly listed.
The magic that enables a decentralised exchange to automatically create markets without relying on the traditional intermediary is a combination of maths and code.
Automated Market Maker Equation
Where a CEX has an Order Book managing offers from buyers and sellers through a centralised system a DEX uses an Automated Market Maker (AMM). An AMM combines Smart Contracts and algorithms to incentivise crypto holders to provide liquidity for trading pairs and automatically adjusts prices based on the changing liquidity ratio.
In its simplest form, the AMM model works on the equation x*y=k. We can illustrate for an example trading pair of BTC/USDT
x = the BTC proportion of the total pool
y = the USDT proportion of the total pool
k = the total liquidity in the pool (x*y)
Automated Market Maker Algorithm
The job of the algorithm is to keep k constant by adjusting the prices of x and y in proportion to trades and incentivising Liquidity Providers (LPs).
If traders buy BTC they diminish that side of the pool and increase the pool of USDT increasing the relative price of BTC. This also incentivises LPs to provide more BTC because liquidity provision is based on the proportion of the overall pool you add, not the specific price at the time.
Price within a DEX doesn’t move based on knowledge of price externally — through an Oracle, for example — but simply because traders will profit from any differentials between the price offered on the DEX and the price elsewhere, for example on a centralised exchange. Exploiting price differential is known as arbitrage and is essential for efficient markets of any sort.
Even with arbitrage helping keep the price offered by a DEX in line with the broader market this doesn’t guarantee that a trade will also be executed efficiently because the size of the trade relative to the volume of the liquidity pool will determine price slippage.
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