Is an Automated Market Maker an Alternative to Fiat Trading Protocols?

Abstract

An automated market maker (AMM) is a relatively new trading protocol that is currently used by some decentralized cryptocurrency exchanges (DEX). An AMM differs from traditional market makers by being “depersonalized” because it is simply a smart contract that taps into an underlying liquidity pool (LP) which is the common property of participating investors rather than in the inventory of a single market maker. The article considers the applicability of AMMs to traditional (fiat) financial markets and, if applicable, whether AMMs might operate as a “sustaining” or “disruptive” technology as defined in The Innovator’s Dilemma. The article begins by showing the validity of taking up such questions, outlines the underlying motivations for moving to an AMM, and argues that AMMs present a challenge to the traditional financial infrastructure and to continuous matching of buyers and sellers via a central limit order book (CLOB) as a predominant trading protocol. AMM structure and algorithms are described, and various AMM models are classified according to their indifference curve design. How AMM pricing relates to market pricing and how arbitrage helps in reaching alignment are then examined together with related problems for traders (slippage, frontrunning, rug pull) and for the investors participating in an LP (impermanent loss, the vulnerability of smart contracts). The article then proposes that, in the near term, AMMs have problems that make their application to traditional markets unlikely. However, in the medium term and provided that certain necessary conditions are met, AMMs in some form may prompt interest outside cryptocurrency markets as a sustaining or even disruptive technology