We investigate the market microstructure of Automated Market Makers (AMMs), the most prominent type of blockchain-based decentralized exchanges. We show that the order execution mechanism yields token value loss for liquidity providers if token exchange rates are volatile.

AMMs are adopted only if their token pairs are of high personal use for investors, or the token price movements of the pair are highly correlated. A pricing curve with higher curvature reduces the arbitrage problem but also investors’ surplus. Pooling multiple tokens exacerbates the arbitrage problem. We provide statistical support for our main model implications using transaction-level data of AMMs.

Full paper link (currently under review at RFS):

https://arxiv.org/pdf/2103.08842