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

Abstract:
We investigate the potential for automated market makers (AMMs) to be economically viable in and improve traditional financial markets. AMMs are a new type of trading institution that have emerged in the world of crypto-assets and process a significant portion of global crypto trading volume. The current trend of tokenizing assets, the legitimization of crypto-token issuance via the EU’s MiCA regulation, and the push by the S.E.C. to change the trading of retail orders presents an opportunity to consider AMMs for traditional markets. Our approach is to determine the parameters that would allow liquidity providers to profitably contribute to an AMM and calculate, based on U.S. equity trading data, if liquidity demanders would benefit from using the AMM for these parameters. Our analysis suggests that properly designed AMMs could save U.S. investors about 30% of annual transaction costs. The source for these savings is twofold: AMMs allow better risk sharing for liquidity providers and they use locked-up capital that otherwise sits idly at brokerages. The introduction of AMMs in traditional markets could particularly improve the liquidity and trading cost issues faced by small firms, allowing them to attract more investors and capital.