Learning from DeFi: Would Automated  
Market Makers  Improve Equity Trading?

Katya Malinova  &   Andreas Park

 

WFA 2024

Honolulu, June 28-30, 2024

McMaster
University		 University of Toronto
  • Blockchain: borderless general purpose value and resource management tool

Preliminaries

  • DeFi: financial applications that run on blockchains
  • \(\Rightarrow\) brought new ideas and tools
  • one new market institution: automated market makers

Decentralized trading using automated market makers (AMM)

Liquidity providers

Liquidity demander

Liquidity Pool

AMM pricing is mechanical:

  • determined by the amounts of deposits 
  • most common:
    • constant product
    • #USDC \(\times\) #ETH = const

No effect on the marginal price

Key Components

  • Our question:
    1. Can an economically viable AMM be designed for current equity markets?
    2. Would such an AMM improve current markets?
  • Pooling of liquidity!
  • Liquidity providers:
    • pro-rated 
      • risk
      • trading fee income
    • use assets that they own to earn passive (fee) income
      • retain exposure to the asset
  • Liquidity demanders:
    • predictable price
    • continuous trading
    • ample liquidity

Existing asset holders, not market makers, do not aim for zero inventory!

Modelling Calibrate-able Liquidity Supply and Demand in an Automated Market Maker

Liquidity providers 

  • Deposit asset & cash when the asset price is \(p\)
  • While in the pool: balanced volume \(V\) + order imbalance \(p\to p'\)
  • Withdraw at price \(p'\)

Buy and hold

Provided liquidity

in the pool

  • \(\Rightarrow\)  positional loss relative to a "buy-and-hold" when \(p'\ne p\)
    • adverse selection
  • Arbitrageurs monitor the pool 
  • \(\Rightarrow\) LPs deposit/writhdraw at efficient prices!

Expected returns to liquidity providers over the "deposit period"

  • \(R\) = asset  return
  • \(F\) = trading fee
  • \(V\) = balanced volume
  • \(a\) = size of the liquidity pool

Similar to Lehar and Parlour (2023), Barbon & Ranaldo (2022).

(incremental) adverse selection loss \(L\) when the asset return is \(R=p'/p\)

fees earned

on informed

fees earned

on balanced flow

for reference:

  • If the asset price \(\searrow\) 10% the incremental  loss \(L\)  for liquidity providers is 13 basis points on the deposit
    • \(\to\) total loss=-10.13%
  • If the asset price \(\nearrow\) 10%, the liquidity provider gains 12 basis points less on the deposit
    • \(\to\) total gain =9.88%

For fixed  balanced volume \(V\) & fee \(F\):

  • Larger pool size \(a \to\) smaller shares of the fees
  • \(\Rightarrow \) LP return \(\searrow\) in pool size
  • Competitive liquidty provision:
    • \(\Rightarrow\) the upper-bound on pool size above which LPs lose money
    • we characterize this by \(\bar{\alpha}\) \(=\) fraction of the asset's market cap to be deposited to the pool

\(=\) 0

Liquidity Demander's Decision & (optimal) AMM Fees

  • Better off with AMM relative to traditional market if
    \[\text{AMM price impact} +\text{AMM fee } F \le \text{bid-ask spread}.\]
  • Two opposing forces when fee \(F\nearrow\) 
    1.  more liquidity provision
      \(\to\) lower price impact
    2. more fees to pay

Result:

competitive liq provision\(\to\) there exists an optimal (min trading costs) fee \(F >0\)

  • \(\to\) derive closed form solution
  • Fee \(F\) depends on asset return  distribution, balanced volume, quantity demanded

Similar to Lehar&Parlour (2023) and Hasbrouck, Riviera, Saleh (2023)

  • Optimal \(F\) is asset-specific to compensate LPs for asset-specific adverse selection losses!
  • Assumption: asset returns are exogenous to  trading (efficient prices)

What's next?

 

  • Calibrate to stock markets
  • AMM Feasible? 
    • Are the AMM costs at the optimal fee \(F\) \(<\) bid-ask spread?

Approach: daily AMM deposits

  1. AMMs close overnight.
     
  2. Market: opening auction \(\to\) \(p_0\)
     
  3. Determine optimal fee \(F\);
    LPs  deposit \(a\) assets and  \(c\) cash at ratio \(p_0=c/a\) until break even \(\alpha=\overline{\alpha}\)
     
  4. Liquidity locked for the day
     
  5. At EOD release deposits and fees
     
  6. Back to 1.

Background on Data

Special Consideration 1: What volume?

  • some volume may be intermediated

  • with AMMs: no need for intermediation
  • \(\to\) intermediated volume could disappear 
  • \(\to\) use volume/2
  • Some caveats, e.g.
    • arbitrageur volumes
    • larger volume if AMM has lower trading costs

Special Consideration 2: What's \(q\) (the representative order size)?

  • use average per day
  • take long-run average + 2 std of daily averages
  • (also avg \(\times 2\),\(\times 4\), depth) 

All displayed data CRSP \(\cap\) WRDS

  • CRSP for shares outstanding
  • WRDS-computed statistics for
    • quoted spreads (results similar for effective)
    • volume
    • open-to-close returns
    • average trade sizes, VWAP
  • Time horizon: 2014 - March 2022
  • Exclude "tick pilot" period (Oct 2016-Oct 2018)
  • All common stocks (not ETFs) (~7550).
  • Explicitly not cutting by price or size
  • All "boundless" numbers are winsorized at 99%.

Special Consideration 3:

Where to get returns and volume?

  • Approach 1: "ad hoc" 
    • "one-day-back" look
    • take yesterday's return and volume when deciding on liquidity provision in AMM
  • Approach 2: estimate historical return distribution

 

AMMs based on historical returns

  • average \(F^\pi=11\)bps

Average of the market cap to be deposited for competitive liquidity provision: \(\bar{\alpha}\approx 2\%\)

almost break even on average (average loss 0.2bps \(\approx0\))

average: 94% of days AMM is cheaper than LOB for liq demanders

average savings: 16 bps

average daily: $9.5K

average annual saving: $2.4 million

implied "excess depth" on AMM relative to the traditional market

Sidebar: Cash deposit requirements

  • Asset provision is not a problem: enough idle liquidity
  • But: AMM requires off-setting cash: \(c =a\cdot p(0)\).
    • ​Cash is not free: at 6% annual rate,  2bps per day.
    • Adds to fees
  • Several solutions:
    1. Narrow a range of returns for which to provide liquidity (akin to Uniswap V3) or circuit breakers
    2. Other mechanisms being developed 
      • ​Balancer protocol: same cash for many assets

\(\Rightarrow \) Need about 5% of the value of the shares deposited -- not 100% --  to cover up to a 10% return decline

Summary

  • AMMs do not require a blockchain - just a concept
  • could be run in the existing world (though there are institutional and regulatory barriers)
  • Our question:
    1. Can an economically viable AMM be designed for current equity markets?
    2. Would such an AMM improve current markets?
  • Answers:
    1. Yes.
    2. Massively.
  • Source of Savings:
    • Liquidity providers \(\not=\)  Citadel! 
    • \(\to\) no (overnight) inventory costs
    • \(\to\) use idle capital
    • \(\to\) + better risk sharing

@katyamalinova

malinovk@mcmaster.ca

slides.com/kmalinova

https://sites.google.com/site/katyamalinova/

Optimal fee \(F^\pi\)

average benefits liquidity provider in bps (average=0)

Insight: Theory is OK - LP's about break even

\(\overline{\alpha}\) for \(F=F^\pi\)

Need about 10% of market cap in liquidity deposits to make this work

actually needed cash as fraction of "headline" amount

Only need about 5% of the 10% marketcap amount in cash

AMMs are better on about 85% of trading days

quoted spread minus AMM price impact minus AMM fee (all measured in bps)

relative savings: what fraction of transactions costs would an AMM save? \(\to\) about 30%

theoretical annual savings in transactions costs is about $15B