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Automated Market Makers.txt
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Automated Market Makers.txt
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Introduction
Some of the modern tools of liquidity provision are Automated Market Makers (AMMs) which are a part of decentralized exchange and based on blockchain. As opposed to the Central Limit Order Books, where buy-sell orders are matched instantly, in AMMs formulas are used for setting the price and swapping the assets without involving counterparties. This novel approach of trading eliminates central facilitators, intermediary consolidations and offers liquidity in a transparent manner. AMMs have become popular especially in terms of DeFi where platforms like Uniswap and Bancor have been typical examples. In the paper Pourpouneh, Nielsen & Ross (2020), the authors discuss the nature of the markets for AMMs, assess the performance of AMMs and compare the advantages and drawbacks of security, liquidity and price searching performance between AMMs and other traditional CLOB exchanges.
Impact
Efficient Liquidity Provision: Perhaps one of the least discussed effects of AMMs is their provision of liquidity without the need to involve an exchange. Thus, this democratization of market-making enables anyone to bring an asset into a liquidity pool to provide liquidity. This is rather different from conventional finance systems where major players spearhead provision of liquidity. In the authors’ view, this innovation opens up entry, improves the accessibility of the market, and allows decentralized platforms to grow in a more effective way.
Price Discovery and Arbitrage: As it has been mentioned earlier, price in the traditional markets is an endogenous variable which is determined by the interaction of supply and demand forces. AMMs, on the other hand, rely on deterministic algorithms for setting price levels and where these are inaccurate, rely on arbitrageurs for correction to ….getExternal markets. Although this helps in the prevention of manipulation of prices by opposing parties, it creates inconvenience to the liquidity providers. This paper measures the amount of money paid by liquidity providers whenever arbitrageurs manipulate price disparities and established that volatility increases losses in the arbitrage process.
Security and Decentralization: AMMs are developed on distributed systems which eliminate vulnerable points such as hacks or a single market influencer. It is not a secret that centralized exchanges are exposed to such risks, as numerous examples of hacks in a crypto market have shown. The security of AMMs lies in decentralization with the use of smart contracts for the swapping of assets. However, it also reveals the fact that AMMs are fundamentally dependent on efficient primary markets for benchmark prices hence are dependent on external systems for price discovery.
Losses for Liquidity Providers: Arbitage opportunities are inevitable in AMMs, and they result in negative transaction fees for the liquidity providers. This paper a thorough analysis of how these losses translates to opportunity costs when the AMM prices diverge from those in the primary markets. The loss increases with higher market volatility which suggests that AMMs are more apt for low volatility assets where these distortions are less significant.
AMMs vs. Traditional Market Models: This paper compares the AMMs with what is known as CLOB models claiming that even though AMMs have advantages of simplicity and automation they do not eliminate the conventional market structures altogether. Whether or not AMMs are able to take on the role of traditional exchanges and be the dominant market structure in Decentralized Finance is still up for debate, what can be concluded is that it is another system that can add liquidity in a decentralized market. Nonetheless, AMMs are suboptimal and less powerful in high-frequency, volatile setting since they apply deterministic pricing algorithms, which adapt slower compared to CLOBs to fluctuations in the markets.
Conclusion
Pourpouneh, Nielsen, and Ross’ (2020) study ends with the observation that, despite the potential of AMMs to deliver on the promise of building more decentralised and easily accessible markets for finance, they are not without their drawbacks. They disintermediate liquidity provision through their model as opposed to the old centralised version of CLOBs. However, as we have seen, the reliance on arbitrage for the determination of the prices clears inefficiency for liquidity providers especially during the volatile periods.The paper notes that it studies the applicability of AMMs and concludes that they perform well with assets of low volatility and requires further research in order for dexes to become effective. Non-etheless, the authors foreseen that when integrated with other decentralised market structures, AMMs can improve the effectiveness of decentralised financial markets by many folds.
References
Pourpouneh, M., Nielsen, K. & Ross, O. (2020). Automated Market Makers. DOR Working Paper No. 2020-08, KU- Denmark, Department of food and resource economics. Available at: https://hdl. handle. net/10419/222424
Adams, H. (2019). "Uniswap," Available: https://docs. uniswap. io/
Beck, R., Avital, M., Rossi, M., & Thatcher, J. B. (2017). Blockchain technology in business and information systems research ‘Blockchain Technology in Business and Information Systems Research’. Business and Information Systems Engineering 6 2018 January, Vol. 59, No. 6: pp. 381 – 384.
Budish, E., Cramton, P., & Shim, J. (2014). "Frequent Batch Auctions: Organizing Markets: Slowing Them Down to the Blink of an Eye. American Economic Association Papers and Proceedings, 104(5), 418–424.