Abstract
Recent advancements in decentralized finance (DeFi) have resulted in a rapid increase in the use of Automated Market Makers (AMMs) for creating decentralized exchanges (DEXs). In this paper, we organize these developments by treating an AMM as a neoclassical black-box characterized by the conversion of inputs (tokens) to outputs (prices). The conversion is governed by the technology of the AMM summarized by an ‘exchange function’. Various types of AMMs are examined, including: Constant Product Market Makers; Constant Mean Market Makers; Constant Sum Market Makers; Hybrid Function Market Makers; and, Dynamic Automated Market Makers. The paper also looks at the impact of introducing concentrated liquidity in an AMM. Overall, the framework presented here provides an intuitive geometric representation of how an AMM operates, and a clear delineation of the similarities and differences across the various types of AMMs.
Highlights
DeFi, decentralized exchanges (DEXs) and Automated Market Makers (AMMs) The latest new thing in the blockchain space is decentralized finance (DeFi) which, broadly, refers to financial digital applications built on decentralized blockchain networks
Instead of using an order book, more recent attempts at establishing DEXs have revolved around the use of automated market makers (AMMs), which is the subset that this paper focuses on
37 Later on, in the secion “Constant Mean Market Makers (CMMM)”, we show that other types of AMMs, such as a Constant Mean Market Maker, have a similar property of fixed shares of value
Summary
DeFi, DEXs and AMMs The latest new thing in the blockchain space is decentralized finance (DeFi) which, broadly, refers to financial digital applications built on decentralized blockchain networks. In contrast to traditional finance that is facilitated by centralized agencies, such as banks and stock exchanges, the promise of DeFi is the elimination of centralized third-parties that act as intermediaries in financial transactions. While it is not clear at this stage whether DeFi will replace traditional financial institutions with their decentralized substitutes, or even if many of the start-ups in this area will eventually survive, the rapidly escalating advancements in DeFi applications suggest that there is a need to step back and correlate ideas in this area with traditional concepts in economics and finance.
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