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Traditional Market Making vs. Automatic Market Making

Written by Nodar
Updated 11 months ago

Market Making in traditional finance: 

  • Most exchanges maintain an order book and facilitate matches between buyers and sellers. 
  • For each successful match, traders are charged exchange fees which go directly to exchange operators.

The DeFi Difference:

  • Smart contracts hold liquidity reserves of various tokens, and trades are executed directly against these reserves. 
  • Prices are set automatically using the constant product market maker mechanism, which keeps overall reserves in relative equilibrium. 
  • Reserves are pooled between a network of liquidity providers who supply the system with tokens and receive a proportional share of transaction fees accrued. 
IMPORTANT NOTE: With fluctuating prices, liquidity providers may incur 'impermanent loss'
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