Liquidity Provision and Automated Market Making
An introduction to constant function market makers (CFMMs), which have emerged as the dominant mechanism for decentralized exchange on blockchains. Ciamac Moallemi (Columbia University) resolves the apparent difference between CFMMs and the dominant mechanism in traditional finance, electronic limit order books. He defines a unifying framework for liquidity provision, and illustrates how CFMMs and limit order books are both mechanisms within this framework. Ciamac then considers the economics of CFMMs from the perspective of liquidity providers (LPs), decomposing the return of an LP into a market risk component and a predictable, increasing adverse selection component called “loss-versus-rebalancing” (LVR). LVR is a new running cost that must be offset by trading fee income for liquidity provision to be profitable, providing a useful benchmark to assess CFMM LP investment decisions. It can also inform the design of CFMM protocols.
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