Discover how automated market makers and decentralized exchanges could revolutionize traditional stock trading by enabling tokenized global investing, breaking barriers of geography and regulation, and democratizing liquidity — while exploring the risks like impermanent loss that every investor should understand.

People invest in stocks mainly due to three reasons. They believe in founders and their vision and want ownership in that mission. Then they get a yield as dividend in a company (if the company is profitable and if they pay dividends). It’s a form of passive returns on your monetary asset which otherwise would lose purchasing power over time due to inflation. The third and most important thing is if the company keeps growing besides the dividend they will get price appreciation from the stock.

Selling stocks via an initial public offering (IPO) is a way for companies to raise money. At some point in time most companies do an IPO, go public and get their stocks listed on an exchange like BSE, NSE, NYSE or NASDAQ. This transformation from a private to public company is driven by a combination of strategic goals. The main reason is to raise large sums of money from public which can be used to expand operations, launch products, pay off debt and or fund acquisitions. An exchange listing provides a venue for early investors and founders to get liquidity. There is a boost to the brand and it helps with access to future capital. Listing on an exchange and interest by the public establishes a liquid market value for the company. But listing on a exchange is costly process too. Not every company can justify those costs.

For any stock exchange or financial market to function efficiently, there must be both buyers and sellers. However, in reality, supply and demand do not always match perfectly. This is where market makers, typically investment banks or specialized trading firms play a crucial role.

The Money-Making world of the Market Maker

Market makers stand ready to buy when there are no immediate buyers and sell when there are no immediate sellers. In doing so, they assume short-term risk to ensure that trading can happen smoothly. Their primary objective is to provide liquidity or the ability to enter or exit positions without significant price disruption. This builds confidence among retail and institutional investors alike, who rely on the assurance that they can transact whenever needed. Rather than making directional bets on the market, market makers aim to remain neutral.

Market makers facilitate trades and, in return, earn a small fee or spread on each transaction. While this fee is often infinitesimal per trade, the high volume of transactions generates meaningful revenue over time. Market makers strive to end each trading day with minimal exposure, often hedging or offloading positions quickly. The focus is not on taking long-term investment risk, but on earning consistent, low-risk returns through volume and efficiency.

This business model has proven highly lucrative for investment banks, who extend this service across asset classes from equities and bonds to derivatives ensuring that clients can buy or sell virtually any security at any time, all at a market-driven price. Contrary to popular belief, when an investor purchases a stock and it subsequently declines in value, the market maker does not profit from the loss. It is the investor who assumes the risk in anticipation of potential reward. The market maker’s role is not to speculate, but to ensure that the marketplace functions efficiently. In essence, market making is not about prediction or speculation, it’s about facilitation, liquidity, and trust. And in the grand machinery of financial markets, it is one of the most vital cogs.

This business model is exceptionally profitable for firms with the scale and the risk management abilities if they execute it well. A prime example is Citadel Securities, one of the largest and most technologically advanced market-makers in the U.S.

In 2023, Citadel Securities generated approximately $2.76 billion in net trading profit, including $725 million in the fourth quarter alone. In the first quarter of 2025, the firm’s net trading revenue surged to $3.4 billion, a 45% increase year-over-year. Besides Citadel there is Goldman Sachs, Sesquahana, Jane Street, Interactive Brokers and many more.

Yet, while the goal is neutrality, market makers do take on risk especially during times of crisis.

Imagine a scenario like the 2008 financial crisis, when the collapse of firms like Lehman Brothers or Bear Stearns became imminent. If the market collectively decides to sell a stock in panic, the market maker is still obligated to buy. Though they can reduce their quote sizes or widen their spreads slightly, they’re often restricted to moving prices down in small increments. In such situations, they may end up accumulating significant positions in free-falling securities; positions that can result in substantial losses. These are rare, high-impact events, but they illustrate that market making is not entirely risk-free.

Entry Restricted

Ordinary investors cannot simply become market makers on exchanges like the NYSE or NASDAQ. While it’s well known that investment banks generate significant profits through market making, replicating those returns isn’t feasible for individuals. Becoming a market maker requires not only a seat on the exchange but also access to vast capital, high-speed infrastructure, and the ability to meet stringent regulatory and compliance requirements. Even if technically permitted, the cost of licensing, technology, and ongoing oversight makes it prohibitively expensive and operationally inefficient for small players.

In short, the system is designed for large institutions — not individual investors. As an ordinary individual investor you cannot take 100 rupees or even 1 crore rupees and say to the exchange I too want to be a market maker and make these kinds of returns like the Citadel or the Goldman Sachs.

A breakthrough idea

Cryptocurrencies were born out of a desire to eliminate middlemen. At their core, they promised a world where money could move peer-to-peer, secured by cryptography, verified by code, and untouched by traditional institutions.

Bitcoin showed that money could be created and transferred without a bank.

Ethereum demonstrated that entire financial systems could be programmed.

But ironically, even as these decentralized technologies gained traction, they were being traded on centralized platforms. These centralized exchanges (CEXs) like Coinbase, Binance, and Kraken acted as custodians of funds and facilitators of trade. While they offered user-friendly interfaces and deep liquidity, they introduced a single point of failure. They were vulnerable to hacks, regulatory pressure, and internal mismanagement. Moreover, listing fees and preferential treatment turned them into gatekeepers; ironically recreating the very intermediaries crypto was supposed to eliminate.

The crypto community recognized the contradiction: decentralized assets were being traded on centralized infrastructure. The solution was as bold as it was elegant, create decentralized exchanges (DEXs), where code, not corporations, matched buyers and sellers. But DEXs faced a fundamental problem.

Traditional markets rely on order books with constantly updated lists of buy and sell offers. Maintaining such a structure on-chain where every action must be recorded on the blockchain would be prohibitively expensive and slow and the initial solutions which were founded in 2017 failed. This bottleneck was shattered in 2018 by Hayden Adams, the founder of Uniswap, who introduced an entirely different concept: the Automated Market Maker (AMM). At the heart of Uniswap was a simple mathematical formula: x * y = k, known as the constant product formula. Instead of using an order book, Uniswap used liquidity pools, pools of two tokens (say, ETH and USDC) and are supplied by users. The formula kept the value of the two tokens in balance, and prices adjusted automatically as trades happened.

Anyone could become a market maker simply by depositing assets into a pool. In return, they earned a share of the trading fees. There were no listing fees, no applications, and no centralized approvals. If you had a token and someone else had another token, you could create a market.

It didn’t matter if you had $1 or $1 billion, the playing field was flat. This democratization of liquidity was a profound shift. Uniswap exploded in popularity. Its success sparked a wave of innovation. Competing DEXs emerged: SushiSwap, Curve, Balancer, PancakeSwap, and more, each with tweaks to the AMM model. Some optimized for stablecoins. Others introduced custom pricing curves, dynamic fees, or multi-token pools.

A whole new world of money-making opportunities

This blossoming ecosystem became known as DeFi (Decentralized Finance), a parallel financial universe built entirely on smart contracts. Today, Total Value Locked (TVL) the amount of capital deposited in DeFi protocols is a key metric for measuring the health and scale of the ecosystem. At its peak in late 2021, DeFi TVL exceeded $180 billion globally, with Uniswap consistently ranking among the top protocols by TVL. There are now derivatives trading on various DEXes.

With this capital came yields. Liquidity providers (LPs) could earn not just trading fees, but also token rewards, governance rights, and compounding interest through various DeFi protocols. Entire financial strategies such “yield farming,” “liquidity mining,” “staking” popped out from thin air due to the human genius, offering double- and even triple-digit annualized returns, albeit with commensurate risk. Despite market cycles and regulatory uncertainty, the core idea remains powerful: open, permissionless, and programmable markets.

Decentralized exchanges are not just an alternative to centralized ones they are a fundamentally new model of how markets can work, driven not by institutions but by incentives and code. In a world where access to capital markets has long been gated by geography, wealth, or identity, DEXs offer a glimpse into a more open future. The revolution is still young, but one thing is clear: finance will never be the same.

This concept now can be brought to regular stock market where shares can be tokenized and traded on a decentralized exchange which will make it possible for someone in India to invest in US stocks and also someone in Malaysia or Nigeria to invest in Indian stocks. Today they cannot send money or invest in stocks outside their country because of regulations in each jurisdiction. This can not only increase liquidity in the market, it can also allow common folks to invest their money into markets that are stable and secure.

Automated market making comes with its own form of risk like impermanent loss. At first glance, providing liquidity on a DEX seems straightforward. You deposit two tokens say ETH and USDC, into a pool and earn a cut of the trading fees. But under the hood, something more complex is happening. Uniswap and most AMMs use the constant product formula: x * y = k, where x and y are the quantities of the two tokens in the pool, and k is a constant.

When someone trades against the pool, this balance shifts. For example, if traders buy ETH from the pool, the ETH reserve shrinks while the USDC reserve grows. The price adjusts automatically, ensuring that the product of the two reserves remains constant. This is how AMMs determine prices algorithmically. Now here’s where impermanent loss kicks in.

Suppose you deposit 1 ETH and 1,000 USDC into a pool when ETH is $1,000. The value of your deposit is $2,000. If ETH then rises to $2,000, arbitrage traders will rebalance the pool — buying USDC and selling ETH until the ratio matches the new market price. The pool will now hold less ETH and more USDC. When you withdraw your funds, you’ll get back fewer ETH and more USDC than you initially put in. If you had just held onto your 1 ETH and 1,000 USDC without providing liquidity, your total portfolio would now be worth $3,000. But because you provided liquidity and the pool auto-adjusted the ratio to keep the product constant, your withdrawal value might only be around $2,829. The $171 difference is your impermanent loss.

Why is it called impermanent? Because the loss is only “realized” if you withdraw your liquidity while the price difference exists. If prices return to their original levels, the loss disappears. However, in practice, prices rarely revert precisely, making the loss more often permanent than not. This phenomenon is more pronounced when the price of the two assets diverges significantly. The assets are volatile (e.g., ETH vs. a new altcoin). The liquidity pool has high trading volume (leading to frequent rebalancing).

So why do people still provide liquidity? Because trading fees (usually 0.3% per trade on Uniswap) and reward incentives (in the form of governance tokens like UNI) can more than offset the impermanent loss. Many liquidity providers run simulations or use DeFi analytics tools to estimate whether their returns will outweigh the risk. Still, it’s a cautionary tale for newcomers: high yield in DeFi is never free. If the numbers look too good to be true, it’s essential to understand the mechanics behind them. Impermanent loss is a feature of the AMM model, not a bug. But knowing it exists and how to navigate it is crucial for anyone venturing into the world of decentralized finance.

Disclaimer

Nithin Eapen is a technologist and entrepreneur with a deep passion for finance, cryptocurrencies, prediction markets and technology. You can write to him at [email protected]