Seminar (Dept. of Finance)

ABSTRACT:

Blockchain-based decentralized exchanges have adopted automated market makers, which are algorithms that aggregate liquidity and make it accessible to traders by automatically setting asset prices. In this paper, we establish a theoretical framework that incorporates coexisting market structures, specifically a limit-order book and a decentralized automated market maker, to investigate the impact of adding the new market-making structure to the existing market environment. We demonstrate that the introduction of automated market makers stimulates disproportionate reactions from informed and noise traders, leading to a positive spillover effect on liquidity in the limit-order market. Furthermore, contrary to the conventional prediction about the impermanent loss, the liquidity supplied to the automated market maker displays a non-monotonic reaction to asset volatility.