The Adoption of Blockchain-based Decentralized Exchanges

TL;DR

This paper analyzes how blockchain-based decentralized exchanges, specifically AMMs, function, highlighting their advantages, limitations, and factors influencing their adoption based on empirical transaction data.

Contribution

It provides a detailed market microstructure analysis of AMMs, revealing how token volatility, user preferences, and design choices impact their efficiency and adoption.

Findings

Token value loss occurs for liquidity providers during volatile exchanges.

High personal use or correlated token pairs increase AMM adoption.

Higher curvature pricing curves reduce arbitrage but decrease investor surplus.

Abstract

We investigate the market microstructure of Automated Market Makers (AMMs), the most prominent type of blockchain-based decentralized exchanges. We show that the order execution mechanism yields token value loss for liquidity providers if token exchange rates are volatile. AMMs are adopted only if their token pairs are of high personal use for investors, or the token price movements of the pair are highly correlated. A pricing curve with higher curvature reduces the arbitrage problem but also investors' surplus. Pooling multiple tokens exacerbates the arbitrage problem. We provide statistical support for our main model implications using transaction-level data of AMMs.