Abstract
Blockchain-based decentralized exchanges (DEXes) are a pre-requisite for the nascent decentralized finance ecosystem. The most successful form of DEX in terms of trading volume are swap exchanges, smart contracts that pool liquidity and that price transactions with a deterministic function. Almost all swap exchanges use a pricing rule that is conceptually problematic as it gives rise to intrinsically profitable front-running opportunities as well as cross-DEX arbitrage. In practice, these shortcomings cause significant network congestion, a negative externality that raises costs for all users and that threatens the long-term viability of the blockchain ecosystem. Calibrated to a low liquidity but frequently used trading pair on UniSwap, the largest DEX for much of 2020/21, about 14% of transactions see an implicit excess cost of at least 50bps, which is orders of magnitude larger than the common trading costs for this pair on centralized exchanges.I further present an alternative pricing rule, based on insights from the market microstructure literature, that does not suffer from these flaws.
Published Version
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