How Do Automated Market Makers (AMMs) Create Arbitrage Opportunities in DeFi?
AMMs use mathematical formulas, such as x y = k, to determine asset prices based on the ratio of tokens in their liquidity pools. When the price of an asset on an external exchange changes, the AMM's price becomes temporarily misaligned.
Arbitrageurs step in to buy the cheaper asset from the AMM and sell it elsewhere (or vice-versa), pushing the AMM's pool ratio back toward the external market price.
Glossar
Automated Market Makers (AMMs)
Architecture ⎊ Automated Market Makers (AMMs) represent a fundamental shift in exchange design, utilizing algorithmic liquidity provision rather than traditional order books.
Arbitrage Opportunities
Opportunity ⎊ Within cryptocurrency, options trading, and financial derivatives, arbitrage opportunities represent discrepancies in pricing across different markets or exchanges for identical or highly correlated assets.
Impermanent Loss
Exposure ⎊ Impermanent loss, a risk inherent in automated market maker (AMM) protocols and liquidity provision, arises from price divergence between assets deposited and their subsequent value upon withdrawal.
Constant Product Formula
Formula ⎊ The Constant Product Formula, a cornerstone of Automated Market Makers (AMMs) prevalent in decentralized finance (DeFi), establishes a mathematical relationship ensuring liquidity pool balance.