The Conceptual Flaws of Decentralized Automated Market Making

Abstract

Decentralized exchanges (DEXs) are an essential component of the nascent decentralized finance (DeFi) ecosystem. The most common DEXs are so-called automated market makers (AMMs): smart contracts that pool liquidity and process trades as atomic swaps of tokens. AMMs price transactions with a deterministic liquidity invariance rule that only uses the AMM’s token deposits as inputs and that has no precedent in traditional finance. Yet, in the context of transparent and open blockchain operations, any liquidity invariance pricing function allows so-called sandwich attacks (akin to front running) that increase the cost of trading and threaten the long-term viability of the DeFi ecosystem. Invariance pricing is also not regret free. Linear pricing rules have similar problems except for uniform pricing, which has regret-free prices and limits sandwich attack profits but which invites excessive order splitting. Comparing trading costs using a model of liquidity provision, constant product pricing is often cheaper except when the variance of the underlying asset is small or when the order is large. This paper was accepted by Will Cong, special issue of Management Science: Blockchains and crypto economics. Funding: A. Park received financial support from the Global Risk Institute and the Social Sciences and Humanities Research Council of Canada [Grant 435-2017-0647]. Supplemental Material: The data files are available at https://doi.org/10.1287/mnsc.2021.02802 .