Price Discovery in Constant Product Markets

36 Pages Posted: 19 Oct 2023

See all articles by Magnus Hansson

Magnus Hansson

Stockholm University - Stockholm Business School

Date Written: September 25, 2023

Abstract

Constant product markets are extensively used by decentralized exchanges within the blockchain ecosystem and are the most common type of automated market maker designs. This paper develops a price discovery framework for constant product markets that comprises three parts. Firstly, I derive a quadratic relationship that expresses trades in terms of price changes. Secondly, I model trade interactions in a structural VAR system. Thirdly, I translate the impulse responses from the VAR to returns through the quadratic equation. The empirical analysis reveals how large trades
carry important market information and how a small but sophisticated group of adversarial traders,
much like high-frequency traders in traditional markets, play a key role in price discovery on the
largest decentralized exchange Uniswap.

Keywords: Price discovery, Constant product market, Automated market maker, Decentralized exchange, Cryptocurrency, Decentralized finance, Blockchain, Ethereum, MEV,

JEL Classification: C55, C57, E42, G12, G14, G23

Suggested Citation

Hansson, Magnus, Price Discovery in Constant Product Markets (September 25, 2023). Available at SSRN: https://ssrn.com/abstract=4582649 or http://dx.doi.org/10.2139/ssrn.4582649

Magnus Hansson (Contact Author)

Stockholm University - Stockholm Business School ( email )

Sweden

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