Can Markets be Fully Automated? Evidence From an “Automated Market Maker”

UNIVERSITY OF TECHNOLOGY SYDNEY
Finance Department
Research Seminars in Finance

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Paper Title: Can Markets be Fully Automated? Evidence From an “Automated Market Maker”

Speaker: Peter O'Neill, University of New South Wales

Time and Date: 12 – 1 pm, Wednesday 17 May 2023 (AEST)

Venue: Face-to-face seminar in room CB08.08.02, Level 8, Building 8, University of Technology Sydney, 14-28 Ultimo Rd, Ultimo, Sydney, Australia (Map of campus)

Abstract and paper:  A new market type, “Automated Market Makers” (AMMs), completely automates trade matching and liquidity provision functions through transparent and deterministic code. This simplicity opens such a market to significant adverse selection costs — but we show they are not only viable but potentially useful. Using a complete record of 39 million AMM transactions from the Uniswap protocol, we show AMMs provide liquidity to over $50bn worth of trades per month. Despite the simplicity of their pricing algorithm, AMMs overcome adverse selection costs in liquidity provision through fees, ensuring the economic viability of their liquidity. We derive an equilibrium model that shows adjustments to the size of the liquidity pools optimize liquidity provision, analogous to traditional market makers adjusting bid-ask spreads. While AMMs currently exist only in cryptocurrencies, we estimate theoretical transaction costs for AMMs in traditional assets by calibrating our equilibrium model to their return and volume properties. We find that for assets with high volume and low volatility (foreign exchange and large-cap equities), AMMs can generate lower transaction costs than traditional market structures.

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