A Better Market Design? ApplyingAutomated Market Makers’ to Traditional Financial Markets, Foley, S., P. O’Neill, and T.J. Putniņš, 2023

What is the core idea behind automated market makers (AMMs)?

AMMs replace human market‐makers with smart contracts that continuously quote prices using a preset formula (e.g., x·y = k), thus democratizing liquidity provision and reducing dependence on intermediaries.

How can AMMs reduce trading costs relative to traditional market‐making?

By eliminating many operational and inventory costs of human market‐makers, and incentivizing multiple small liquidity providers to compete, AMMs can tighten bid‐ask spreads and lower transaction fees.

Why might AMMs be especially beneficial for high‐volume, low‐volatility asset classes?

In such markets, AMMs’ constant‐function pricing can handle frequent trades with minimal price shifts, and continuous liquidity drives lower spreads than traditional models, enhancing cost efficiency.

What is the constant‐function pricing approach (e.g., x·y = k)?

It’s a formula that automatically adjusts an asset’s price based on trade size and liquidity in the pool, ensuring continuous quotes without needing manual updates from human market‐makers.

Name two drawbacks of AMMs, despite their lower costs.

1. Adverse selection – Informed traders may exploit lagging price updates in the pool.

2. Impermanent loss – Liquidity providers face losses if asset prices move significantly away from the pool’s initial ratio.

What is adverse selection in the context of AMMs?

It occurs when informed traders exploit outdated quotes in the AMM’s pool, trading against the pool at favorable prices before it can adjust, potentially harming liquidity providers.

How are AMM liquidity providers compensated for the risks they take on?

They earn a portion of the trading fees generated by every swap in the pool. These fees aim to offset adverse selection and impermanent loss risks.

Why might AMMs work well for “stable‐stable” asset pairs?

If price volatility is minimal, the risk of impermanent loss is lower, and adverse selection is less severe, allowing stable returns to liquidity providers and more predictable pricing for traders.

Summarize why the authors believe AMMs could enhance market efficiency in traditional finance.

AMMs potentially offer lower spreads, continuous liquidity, and broad‐based liquidity provision, all of which reduce costs and improve the speed and reliability of executing trades in certain asset classes.

In one sentence, how can AMMs lead to lower financial market trading costs?

By automating market‐making through smart contracts and pooling liquidity from many providers, AMMs reduce traditional overhead and tighten bid‐ask spreads, thus lowering overall transaction costs.