What Are Automated Market Makers and Why Do They Matter?

In the world of traditional trading, automated market makers are a relatively new technology. Automation replaced human market makers who were the worker bees of trading pits. For decades, manually created order books were seen as a staple of the industry. Then came computers and the trading models at the time had to be upgraded because of the benefits provided by the technology.

Well, the same thing has happened again with the introduction of cryptocurrency exchanges and blockchain technologies like smart contracts. Digitex Futures plans to take full advantage of this innovative technology and apply it to trading cryptocurrency futures contracts.

Most newcomers to the crypto trading space may be wondering 1) What’s an automated market maker? 2) How do they matter in the world of trading cryptocurrencies? To answer these questions, we have to take a little step back and look at how order books worked before automation. Stay with me.

Before the Days of Automation

First, let’s start by breaking down what an “order book” is. It is a market mechanism (tool) used to list all buy and sell orders; showing the quantity and price of the assets. Back in the day, (meaning around the 90s), before the internet’s full potential was understood, there’d be a room full of people who had to complete these order books by ‘hand’ and match the buyer and seller orders. Yeah, imagine that.

Aside from how much time was wasted on aggregating all the data, this method had a few issues. Things like slippage and latency in price discovery because of the snail’s pace of creating order books became accepted as inherent in the system. However, the bigger issue of newspapers front pages highlighting price manipulation involving market makers like Nasdaq and NYSE didn’t help with job security for human market makers.

Early Days of Automation

Without taking a trip down memory lane; it should be noted one of the first financial institutions to use automated market makers was Shearson Lehman and Brothers. The idea was simple, use the technology at the time to reduce the chances of human manipulation and bring liquidity to the market.

Automated market makers are essentially algorithms (programs); rules saying “if this, then that”, i.e. if the price of an asset moves up or down, then take action. Now granted there is some pretty complicated math involved but we’re not here to get technical. And so was born the high octane world of high-frequency trading.

Most traders and companies who lasted through the automation shift would argue there are no questions to the benefit of automation and how it reflected positively on the bottom line. Remember back then and even now, whether you win or lose, there is a commission fee to pay.

The Benefits of Automation

Automated market makers changed the landscape of trading. The efficiencies gained by utilizing the automated programs had several positive effects on the market and industry as a whole:

  1. New trading models were created based on the technology.
  2. Price slippage between the execution of trades could count as less than a penny.
  3. Order books were created in seconds and for a fraction of the cost.
  4. Latency on trade calls measured in milliseconds instead of seconds.
  5. The markets developed high liquidity.
  6. Help to reduce the ability and number of bad actors doing things like front-running, price manipulation, and wash trading.

Trading houses were happy because price fluctuation was reduced to acceptable levels meaning less slippage. Institutional investors saw new net profit margins. Even retail traders seemed happier because the system seemed fairer.

Automated Market Makers Meet Blockchain Technology

Nearly three decades after the introduction of the algorithms, they are standard backend technology for any conventional trading firm.

Blockchain technology has led to another advancement in the trading realm. History has shown us, once the technology utilized in the industry evolves, so too must the business models used in that industry.

Today’s crypto trading environment runs on a 24 hour, 7 days a week, 365 days business cycle. Terms like the weekend, market closing, business hours, close of business, or after-hours trading no longer apply. Crypto exchanges and futures exchanges are the perfect playgrounds for automated market makers.

What Does This Mean for Crypto Futures Contracts?

Remember the second question mentioned earlier. Well here is the answer, with Digitex Futures, traders use the native DGTX token to place bets on the price fluctuation of Bitcoin, Litecoin, and Ethereum (the assets) by opening futures contracts.

Here is the connect, “automated” in the context of trading means liquidity. Digitex will use the automated market makers AKA trading bots to help provide liquidity in the market. Unlike people, bots don’t need personal time off, have personal lives to distract them from work, and don’t work for commission.

The bots are programmed to match orders and merely break even. They have been capitalized with 20% ($200M) of the total token supply of DGTX.

Now take the ability of traders holding DGTX to make zero-fee trades, and you have a market growing to attract more traders by lowering the barrier to entry. In addition to providing a space to try out more aggressive trading models, this helps the developers on the backend to create better tools for traders.

Smart contracts used in conjunction with automated market makers help to reduce the level of trust traders need to place in the exchange. Trades are executed in a smart contract which is done off-chain. The automated market makers are in communication directly with the smart contract with no need for human interaction, in turn, functioning as a decentralized digitized broker.

Wrapping It Up

Innovation helped to streamline the process of creating order books and matching orders. It also helped the industry clean up its public image by culling bad actors in the space. The benefits of automated market makers to trading have added liquidity and make the market less susceptible to human manipulation.

By Digitex Futures combining automated and blockchain technology, it will help become a leading example of a trustless cryptos futures exchange. Leveling the playing field for traders new to crypto futures trading by eliminating commission fees, and encouraging the more seasoned traders with new trading models and tools.