IDEAS home Printed from https://ideas.repec.org/a/eee/corfin/v91y2025ics0929119925000057.html
   My bibliography  Save this article

The economics of Constant Function Market Makers

Author

Listed:
  • Fabi, Michele
  • Prat, Julien

Abstract

We use microeconomic theory to describe the inner workings of Constant Function Market Makers (CFMMs). We show that standard results from consumer theory apply in this new context, endowing us with powerful tools to characterize the optimal design of CFMMs. We employ them to analyze the externalities that traders and liquidity providers exert on each other when interacting through a CFMM. Liquidity providers reduce the execution costs by flattening the bonding curve on which trades are executed. Arbitrageurs impose an adverse selection cost on liquidity providers by unfavorably rebalancing their portfolio. We show that the strengths of these two externalities are pinned down by the curvature of the bonding curve and are inversely related to each other, thereby identifying the fundamental economic tradeoff that market designers have to address.

Suggested Citation

  • Fabi, Michele & Prat, Julien, 2025. "The economics of Constant Function Market Makers," Journal of Corporate Finance, Elsevier, vol. 91(C).
    • Handle: RePEc:eee:corfin:v:91:y:2025:i:c:s0929119925000057
    DOI: 10.1016/j.jcorpfin.2025.102737
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0929119925000057
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.jcorpfin.2025.102737?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Jiahua Xu & Krzysztof Paruch & Simon Cousaert & Yebo Feng, 2021. "SoK: Decentralized Exchanges (DEX) with Automated Market Maker (AMM) Protocols," Papers 2103.12732, arXiv.org, revised Mar 2023.
    2. Alexander Port & Neelesh Tiruviluamala, 2022. "Mixing Constant Sum and Constant Product Market Makers," Papers 2203.12123, arXiv.org, revised Apr 2022.
    3. Guillermo Angeris & Hsien-Tang Kao & Rei Chiang & Charlie Noyes & Tarun Chitra, 2019. "An analysis of Uniswap markets," Papers 1911.03380, arXiv.org, revised Feb 2021.
    4. Guillermo Angeris & Akshay Agrawal & Alex Evans & Tarun Chitra & Stephen Boyd, 2022. "Constant Function Market Makers: Multi-asset Trades via Convex Optimization," Springer Optimization and Its Applications, in: Duc A. Tran & My T. Thai & Bhaskar Krishnamachari (ed.), Handbook on Blockchain, pages 415-444, Springer.
    5. Jean-Charles Rochet & Jean Tirole, 2003. "Platform Competition in Two-Sided Markets," Journal of the European Economic Association, MIT Press, vol. 1(4), pages 990-1029, June.
    6. Samuel Cohen & Marc Sabat'e Vidales & David v{S}iv{s}ka & {L}ukasz Szpruch, 2023. "Inefficiency of CFMs: hedging perspective and agent-based simulations," Papers 2302.04345, arXiv.org.
    7. Guillermo Angeris & Tarun Chitra, 2020. "Improved Price Oracles: Constant Function Market Makers," Papers 2003.10001, arXiv.org, revised Jun 2020.
    8. Mas-Colell, Andreu & Whinston, Michael D. & Green, Jerry R., 1995. "Microeconomic Theory," OUP Catalogue, Oxford University Press, number 9780195102680, Decembrie.
    9. Jason Milionis & Ciamac C. Moallemi & Tim Roughgarden, 2023. "Automated Market Making and Arbitrage Profits in the Presence of Fees," Papers 2305.14604, arXiv.org.
    10. Johannes Rude Jensen & Mohsen Pourpouneh & Kurt Nielsen & Omri Ross, 2021. "The Homogenous Properties of Automated Market Makers," Papers 2105.02782, arXiv.org.
    11. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
    12. Mark Armstrong & Julian Wright, 2007. "Two-sided Markets, Competitive Bottlenecks and Exclusive Contracts," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 32(2), pages 353-380, August.
    13. Guillermo Angeris & Alex Evans & Tarun Chitra, 2020. "When does the tail wag the dog? Curvature and market making," Papers 2012.08040, arXiv.org.
    14. Guillermo Angeris & Alex Evans & Tarun Chitra, 2021. "Replicating Market Makers," Papers 2103.14769, arXiv.org.
    15. Agostino Capponi & Ruizhe Jia, 2021. "The Adoption of Blockchain-based Decentralized Exchanges," Papers 2103.08842, arXiv.org, revised Jul 2021.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Guillermo Angeris & Akshay Agrawal & Alex Evans & Tarun Chitra & Stephen Boyd, 2021. "Constant Function Market Makers: Multi-Asset Trades via Convex Optimization," Papers 2107.12484, arXiv.org.
    2. Marcello Monga, 2024. "Automated Market Making and Decentralized Finance," Papers 2407.16885, arXiv.org.
    3. Neelesh Tiruviluamala & Alexander Port & Erik Lewis, 2022. "A General Framework for Impermanent Loss in Automated Market Makers," Papers 2203.11352, arXiv.org.
    4. Raphael Auer & Bernhard Haslhofer & Stefan Kitzler & Pietro Saggese & Friedhelm Victor, 2024. "The technology of decentralized finance (DeFi)," Digital Finance, Springer, vol. 6(1), pages 55-95, March.
    5. Maxim Bichuch & Zachary Feinstein, 2022. "Axioms for Automated Market Makers: A Mathematical Framework in FinTech and Decentralized Finance," Papers 2210.01227, arXiv.org, revised Feb 2025.
    6. Guillermo Angeris & Alex Evans & Tarun Chitra, 2021. "Replicating Monotonic Payoffs Without Oracles," Papers 2111.13740, arXiv.org.
    7. Alif Aqsha & Philippe Bergault & Leandro S'anchez-Betancourt, 2025. "Equilibrium Reward for Liquidity Providers in Automated Market Makers," Papers 2503.22502, arXiv.org.
    8. Daniel Kirste & Niclas Kannengie{ss}er & Ricky Lamberty & Ali Sunyaev, 2023. "Automated Market Makers in Cryptoeconomic Systems: A Taxonomy and Archetypes," Papers 2309.12818, arXiv.org, revised Mar 2025.
    9. Viraj Nadkarni & Sanjeev Kulkarni & Pramod Viswanath, 2024. "Adaptive Curves for Optimally Efficient Market Making," Papers 2406.13794, arXiv.org, revised Mar 2025.
    10. Guillermo Angeris & Alex Evans & Tarun Chitra, 2023. "Replicating market makers," Digital Finance, Springer, vol. 5(2), pages 367-387, June.
    11. Tobias Bitterli & Fabian Schar, 2023. "Decentralized Exchanges: The Profitability Frontier of Constant Product Market Makers," Papers 2302.05219, arXiv.org, revised Mar 2023.
    12. Vijay Mohan, 2022. "Automated market makers and decentralized exchanges: a DeFi primer," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 8(1), pages 1-48, December.
    13. C. Escudero & F. Lara & M. Sama, 2024. "Optimal Trade Characterizations in Multi-Asset Crypto-Financial Markets," Papers 2405.06854, arXiv.org.
    14. Moraga-Gonzalez, Jose L. & Wildenbeest, Matthijs R., 2011. "Comparison sites," IESE Research Papers D/933, IESE Business School.
      • Jose Luis Moraga-Gonzalez & Matthijs R. Wildenbeest, 2011. "Comparison Sites," Working Papers 2011-04, Indiana University, Kelley School of Business, Department of Business Economics and Public Policy.
    15. Attila Ambrus & Emilio Calvano & Markus Reisinger, 2016. "Either or Both Competition: A "Two-Sided" Theory of Advertising with Overlapping Viewerships," American Economic Journal: Microeconomics, American Economic Association, vol. 8(3), pages 189-222, August.
    16. James E. Prieger & Wei‐Min Hu, 2012. "Applications Barrier To Entry And Exclusive Vertical Contracts In Platform Markets," Economic Inquiry, Western Economic Association International, vol. 50(2), pages 435-452, April.
    17. Cenamor, Javier, 2021. "Complementor competitive advantage: A framework for strategic decisions," Journal of Business Research, Elsevier, vol. 122(C), pages 335-343.
    18. Elias Carroni, 2018. "Behaviour-based price discrimination with cross-group externalities," Journal of Economics, Springer, vol. 125(2), pages 137-157, October.
    19. Hui Li & Qiaowei Shen & Yakov Bart, 2018. "Local Market Characteristics and Online-to-Offline Commerce: An Empirical Analysis of Groupon," Management Science, INFORMS, vol. 64(4), pages 1860-1878, April.
    20. repec:ebl:ecbull:v:12:y:2007:i:7:p:1-8 is not listed on IDEAS
    21. Siciliani, Paolo & Giovannetti, Emanuele, 2019. "Platform competition and incumbency advantage under heterogeneous switching cost — exploring the impact of data portability," Bank of England working papers 839, Bank of England.

    More about this item

    Keywords

    Automated Market Makers; Decentralized Finance; Blockchain; Market Design;
    All these keywords.

    JEL classification:

    • D47 - Microeconomics - - Market Structure, Pricing, and Design - - - Market Design
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:corfin:v:91:y:2025:i:c:s0929119925000057. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/jcorpfin .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.