Abstract
A growing number of blockchain-based decentralized exchanges (DEX) have adopted constant product market makers (CPMM)—a single-function algorithm to pin down the execution price for a trade. We build a model of coexisting exchanges, in which a centralized exchange (CEX) with the traditional order-book mechanism operates in parallel with a DEX with the CPMM. Traders are either informed or uninformed and endogenously choose their trading venue. The model first shows that liquidity on the DEX is positively associated with that on the CEX. Moreover, market makers' profits on the DEX are determined by asymmetric information between informed traders and market makers, as in the traditional market microstructure theory. Based on that, we describe market makers' equilibrium venue choice and endogenize the amount of liquidity on the DEX. Our model also shows that informed buy and sell orders exhibit an asymmetric reaction to higher asset volatility, implying heterogeneity in the informativeness of buy and sell order flow.
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