The Pricing And Hedging Of Constant Function Market Makers

TL;DR

This paper models the market microstructure of constant function market makers (CFMMs) on blockchains, providing valuation methods for liquidity providers and derivatives, and analyzing trader behavior and equilibrium prices.

Contribution

It introduces a novel model for valuing LPs and derivatives in CFMMs, incorporating trader information asymmetry and equilibrium price distributions.

Findings

Developed a valuation model for LPs and derivatives in CFMMs

Simulated trader behaviors with different information levels

Analyzed equilibrium price distributions under trader arrivals

Abstract

We investigate the most common type of blockchain-based decentralized exchange, which are known as constant function market makers (CFMMs). We examine the the market microstructure around CFMMs and present a model for valuing the liquidity provider (LP) mechanism and estimating the value of the associated derivatives. We develop a model with two types of traders that have different information and contribute methods for simulating the behavior of each trader and accounting for trade PnL. We also develop ideas around the equilibrium distribution of fair price conditional on the arrival of traders. Finally, we show how these findings might be used to think about parameters for alternative CFMMs.