The Arbitrageurs’ Market Maker
Beware the narratives - AMMs are a delight for arbitrageurs, and a sinister way to extract money from unwilling supporters.
While AMMs are ubiquitous in crypto exchanges, there is nothing inherently blockchain-native about them. Many different order matching models have been tried and tested across time, but liquid markets are almost exclusively Central Limit Order Books (CLOBs), across all asset classes. Why?
A quick recap: markets exist to enable genuine end users (hedgers, speculators and so on) to find each other with minimal cost and friction. A secondary objective is clear, transparent pricing; this enables economic information to flow quickly and without friction, which is the cornerstone of any market economy.
Amongst many equals, one participant is special: the market maker. In a CLOB, market makers constantly place buy and sell orders to match genuine end buyers and sellers that arrive at the market at different points in time, want to transact in different sizes, or don’t know what price it is fair to transact at. As long as they buy, on average, at prices lower than they sell, they make a profit regardless of market direction.
This is part of the beauty of CLOBs - by incentivizing this correctly, we create a competitive structure that effectively commoditizes market function into a labour- and capital-intensive business, and creates better outcomes for all genuine participants.
In the early days of DeFi, a narrative began to emerge that CLOB market making PnL is value-extractive, and should be centralized and distributed amongst the community. Sounds like communism, right?
This was no doubt fueled by many of the predatory practices of some crypto trading firms, which were certainly not making markets. AMMs also conveniently solved new exchanges’ cold-start problem: by inviting their community to contribute cash towards a liquidity provision, they in effect were letting them invest in a community-backed market making firm which the protocol couldn’t fuel themselves. With just a single market maker in place, there is no need for a CLOB to track the priorities of different market makers, either.
Liquidity provision, however, is brutal work. By placing orders for others to trade against, the market maker is constantly selling options to other market participants to trade against. He will only trade if somebody fancies their price. What does the taker know here that our market maker doesn’t? Did the price just move somewhere else? Maybe there is a big buyer coming that he doesn’t know about? This is a constant problem known as adverse selection that is exploited by arbitrageurs. Market makers are constantly in competition to refine their models and pick up the best flow, which unwittingly provides end users with the best service and spreads.
So how do AMMs avoid these problems? They don’t!!
An AMM is a market maker who is always quoting (in CLOB terms) a two-sided market, but with nobody working full-time on avoiding adverse selection. When the price of an asset moves, arbitrageurs pick off the AMM and move the price back in line. The service of market making shifts to arbitrageurs, along with the PnL - there is no saving! Unlike a CLOB, where market making is done by professional firms who can recalibrate, AMMs lose money for their community backers any time there is any volatility. Last cycle, protocols tried to explain this as ‘Impermanent Loss’ - a psyop that has now mercifully mostly been debunked.
Showing prices is necessarily brutal, labour intensive work, and anyone who tries to tell you otherwise is putting you in a barrel to be shot by those who know. Optimal market models must reward liquidity providers for their service, and encourage competition to get the best possible deal for takers: something CLOBs do best. By design, AMM-based markets are destined to end badly for their backers.