The Adoption of Blockchain-based Decentralized Exchanges
70 Pages Posted: 17 Mar 2021 Last revised: 1 Jun 2022
Date Written: March 15, 2021
We show that pricing curves implemented by automated market makers allow arbitrageurs to extract profits from liquidity providers. This raises the cost of liquidity provision, and may lead to a liquidity freeze if token pairs are too volatile. A more convex pricing curve results in higher price impact, which inhibits arbitrage but also reduces investors' surplus. The convexity of the socially optimal pricing curve is higher for more volatile token pairs. Our empirical analysis reveals that gas price volatility is 60% lower for stable-coin pairs, and that deposit inflows are negatively correlated with volatility, and positively correlated with trading volume.
Keywords: Cryptocurrency, FinTech, Decentralized Finance (DeFi), Market Microstructure
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