Liquidity Provision by Automated Market Makers

27 Pages Posted: 15 Oct 2020 Last revised: 24 Aug 2022

See all articles by Jun Aoyagi

Jun Aoyagi

HKUST, Finance Department

Date Written: May 14, 2020

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

Suggested Citation

Aoyagi, Jun, Liquidity Provision by Automated Market Makers (May 14, 2020). Available at SSRN: https://ssrn.com/abstract=3674178 or http://dx.doi.org/10.2139/ssrn.3674178

Jun Aoyagi (Contact Author)

HKUST, Finance Department ( email )

CA
United States

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