The economics of constant function market makers

Michele Fabi () and Julien Prat ()
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Michele Fabi: CREST - Centre de Recherche en Economie et Statistique [Bruz] - ENSAI - Ecole Nationale de la Statistique et de l'Analyse de l'Information [Bruz], ECO-Télécom Paris - Equipe Eco Economie - CREST - Centre de Recherche en Économie et Statistique - ENSAI - Ecole Nationale de la Statistique et de l'Analyse de l'Information [Bruz] - X - École polytechnique - IP Paris - Institut Polytechnique de Paris - ENSAE Paris - École Nationale de la Statistique et de l'Administration Économique - IP Paris - Institut Polytechnique de Paris - CNRS - Centre National de la Recherche Scientifique, SES - Département Sciences Economiques et Sociales - Télécom Paris - IMT - Institut Mines-Télécom [Paris] - IP Paris - Institut Polytechnique de Paris
Julien Prat: CNRS - Centre National de la Recherche Scientifique, X - École polytechnique - IP Paris - Institut Polytechnique de Paris, CREST - Centre de Recherche en Economie et Statistique [Bruz] - ENSAI - Ecole Nationale de la Statistique et de l'Analyse de l'Information [Bruz], IP Paris - Institut Polytechnique de Paris

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Abstract: We use microeconomic theory to describe the inner workings of Constant Function Market Makers (CFMMs). We show that standard results from consumer theory apply in this new context, endowing us with powerful tools to characterize the optimal design of CFMMs. We employ them to analyze the externalities that traders and liquidity providers exert on each other when interacting through a CFMM. Liquidity providers reduce the execution costs by flattening the bonding curve on which trades are executed.Arbitrageurs impose an adverse selection cost on liquidity providers by unfavorably rebalancing their portfolio. We show that the strengths of these two externalities are pinned down by the curvature of the bonding curve and are inversely related to each other, thereby identifying the fundamental economic tradeoff that market designers have to address.

Keywords: Automated Market Makers Decentralized Finance Blockchain Market Design. JEL Code: D47 D53; Automated Market Makers; Decentralized Finance; Blockchain; Market Design (search for similar items in EconPapers)
Date: 2024
Note: View the original document on HAL open archive server: https://hal.science/hal-04920095v1
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Persistent link: https://EconPapers.repec.org/RePEc:hal:wpaper:hal-04920095

DOI: 10.1016/j.jcorpfin.2025.102737

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