Liquidity Provision by Automated Market Makers

Abstract

A growing number of blockchain-based decentralized exchanges have adopted automated market makers (AMMs) to execute trades. I study the equilibrium liquidity provision via AMMs when traders face the asymmetric information problem. The model pins down the optimal liquidity provision, competition between liquidity providers (LPs), and the aggregate size of the liquidity pool on an automated market. An LP adjusts liquidity supply weighing the adverse selection cost of informed trading against positive profits of random noise trading. The optimal liquidity supply of each LP exhibits a non-monotonic reaction to her rivals' liquidity supply. The model suggests that the equilibrium size of market liquidity tends to be stable.

Keywords: automated market makers, constant product market makers, decentralized exchanges, Uniswap, blockchain, strategic liquidity provision