Uniswap and automated market makers, explained

Bugs, improper pricing and impermanent loss

Despite some positive qualities, AMMs present certain risks and limitations. Hacks and vulnerabilities have already affected exchanges such as Uniswap and Balancer, where some liquidity providers saw their money stolen due to complex smart contract interactions. On the other hand, traders are exposing their strategy for the world to see, enabling front-runners to get their orders in first and exploit legitimate users.

Related: Figuring Out Who’s to Blame for DeFi’s Persistent Security Issues

Automated market makers also cannot exist without traditional order book exchanges being relied upon for arbitrage. The mathematical formulas, despite their elegance, cannot truly represent market sentiment. Arbitrage traders are necessary to correct the pricing of assets in an AMM, but this results in the issue of impermanent loss on many platforms.

In a nutshell, arbitrage traders make a profit by bringing the price in balance, but this profit is extracted from the liquidity providers. Despite the trading fees they receive, liquidity providers may actually lose money if the price moves too far in a certain direction. The loss is “impermanent” because the price could always move in the opposite direction, but in practice, this will not always happen.

While there are certain improvements being made, the volume and liquidity of AMMs still pale in comparison with the largest centralized exchanges. Gas congestion in the summer of 2020 also showed that they are starting to hit their use ceiling, and better scaling solutions will be required in the future to facilitate further growth.