A better market design?Applying “Automated Market Makers” to traditionalfinancial markets Flashcards
What is an Automated Market Maker (AMM), and how does it differ from traditional market-making systems?
An AMM is a market where liquidity providers create a pool of assets, and traders trade against this pool instead of interacting with individual market makers. Smart contracts set the price after each trade, resulting in a passive market with a pool of goods, function, and demand. Unlike traditional market makers who set quotes on goods, AMMs allow demand liquidity providers to drive prices.
What are some risks that liquidity providers (LPs) face in an AMM, and how do they affect LP returns?
Liquidity providers face inventory risk, where they hold both assets in case of a shock in demand for one or the other asset, and adverse selection risk, where LPs cannot adjust prices, resulting in losses if prices change. LP returns are influenced by these risks, with returns being positive when covering the adverse selection risk when including fee yields.
How do market makers make money in AMMs compared to traditional market-making systems?
In AMMs, market makers manage liquidity provided by LPs and the fees they receive. As the pool becomes more lucrative, more LPs join, but fee yield falls, leading to a decrease in total profits for LPs. Conversely, in traditional market-making systems, market makers profit from the spread between buy and sell prices, with tighter spreads in more liquid markets.
What factors influence the allocation of liquidity in AMMs?
Liquidity providers decide to allocate their liquidity based on long-term goals and the relationship between inflow of liquidity, fee yields, and returns. Traders are more likely to trade in pools with lower fees, which come from larger liquidity pools, leading to a positive relationship between pool sizes and trade volumes.
In what scenarios is the application of AMMs feasible in traditional financial markets?
AMMs are feasible in markets characterized by low volatility and high volume, where liquidity providers can cover risks through fee yields. However, the adverse selection risk poses a challenge, and AMMs may not be suitable for all market types.
