Learning from DeFi: Would Automated Market Makers Improve Equity Trading?

Abstract

We explore the potential for automated market makers (AMMs) to enhance traditional financial markets, drawing on their success in the crypto-assets space. The increasing tokenization of assets and regulatory changes, including the SEC’s initiatives to reshape retail order trading, underscore the relevance of considering AMMs in traditional markets. Our study establishes a practical framework to evaluate the viability of AMM liquidity provision in equities and assess if AMMs offer improvements over traditional markets. Analyzing U.S. equity trading data, we find that well-designed AMMs could save U.S. investors billions annually. These savings arise from the distinct characteristics of AMMs, especially the improved risk-sharing and the role of long-term asset holders as liquidity providers. Unlike traditional market makers, long-term asset holders in AMMs seek compensation only for incremental intraday risk relative to a buy-and-hold strategy. They utilize locked-up capital that would otherwise remain idle at brokerages. Small firms, in particular, can benefit by attracting more investors and capital through this approach.

Keywords: automated market makers, blockchain, defi, decentralized finance, trading, microstructure, equity trading, trading costs

JEL Classification: G10, G14