Abstract
We investigate the market microstructure of Automated Market Makers (AMMs), the most prominent type of blockchain-based decentralized exchanges. We show that the order execution mechanism yields token value loss for liquidity providers if token exchange rates are volatile. AMMs are adopted only if their token pairs are highly correlated, or of high personal use for investors. A pricing curve with higher curvature makes the arbitrage problem less severe but also decreases investors’ surplus. Pooling multiple tokens exacerbates the arbitrage problem. We provide statistical support for our main model implications using transaction-level data of AMMs.
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