Invariants, Arbitrage, and Automated Market Makers

Speaker: Roger Lee (University of Chicago)

In a universal framework that expresses any market system in terms of state transition rules, we prove that every DeFi market system has an invariant function and is thus by definition a CFMM; indeed, all automated market makers (AMMs) are CFMMs. Invariants connect directly to arbitrage and to completeness, according to two fundamental equivalences. First, a DeFi market system is, we prove, arbitrage-free if and only if it has a strictly increasing invariant, where arbitrage-free means that no state can be transformed into a dominated state by any sequence of transactions. Second, the invariant is, we prove, unique if and only if the market system is complete, meaning that it allows transitions between all pairs of states in the state space, in at least one direction. Our examples illustrate (non)existence of various specific types of arbitrage in the context of various specific types of market systems – with or without fees, with or without liquidity operations, and with or without coordination among multiple pools – but the fundamental theorems have full generality, applicable to any DeFi market system and to any notion of arbitrage expressible as a strict partial order

Optimal Fees for Liquidity Provision in Automated Market Makers

Speaker: Steven Campbell (Columbia University)

We aim to understand how the profitability of passive liquidity provision in an automated market maker (AMM) depends on the transaction fee and other market characteristics. To that end, we simulate an ecosystem where an aggregator routes order flow to a centralized exchange and the AMM. Our analysis may inform how variable fee mechanisms can be designed to mitigate systematic losses for liquidity providers. Work-in-progress with Philippe Bergault, Jason Milionis, Marcel Nutz

Decentralizing Monopolistic Power in DeFi

Speaker: Sarit Markovich (Northwestern University, Kellogg)

The paper examines the growing trend of private and exclusive orderflow on the Ethereum network, where transactions are hidden from the public mempool to protect traders from frontrunning and sandwich attacks. While private orderflow enhances privacy, exclusive orderflow sends transactions to a single builder, who prioritizes them for block inclusion and refunds part of the Maximum Extractable Value (MEV) to the user. We explore theoretically and empirically how exclusive orderflow negatively affects decentralization by allowing builders to capture a larger share of block value, reducing validators' ability to retain MEV.

What Drives Liquidity on Decentralized Exchanges? Evidence from the Uniswap Protocol

Speaker: Xin Wan (Uniswap)

We study liquidity on decentralized exchanges (DEXs), identifying factors at the platform, blockchain, token pair, and liquidity pool levels with predictive power for market depth metrics. We introduce the v2 counterfactual spread metric, a novel criterion which assesses the degree of liquidity concentration in pools using the ``concentrated liquidity'' mechanism, allowing us to decompose the effect of a factor on market depth into two channels: total value locked (TVL) and concentration. We further explore how external liquidity from competing DEXs and private inventory on DEX aggregators influence market depth. We find that (i) gas prices, returns, and a DEX's share of trading volume affect liquidity through concentration, (ii) internalization of order flow by private market makers affects TVL but not the overall market depth, and (iii) volatility, fee revenue, and markout affect liquidity through both channels.

Competition in the Cryptocurrency Exchange Market

Speaker: Anthony Lee Zhang (University of Chicago, Booth)

Cryptocurrency exchange market structure is fragmented, since cryptocurrencies are fungible, but customers cannot move freely across cryptocurrency exchanges. We build a model where exchanges with captive customers are linked by arbitrageurs, showing that “star-shaped” equilibria can exist, in which arbitrageurs endogenously coordinate on one exchange as a liquidity hub. The model predicts that large exchanges’ listing decisions should influence price dispersion, arbitrage flows, trade volumes, and listing decisions on small exchanges. We provide evidence for the model’s predictions using data on exchange prices and trade volumes, as well as blockchain token flows across exchanges.

The Economics and Design of the Ethereum Blob Fees Market

Speaker: Jason MIlionis (Columbia University)

Ethereum has adopted a roadmap focused on scaling by making rollups (off-chain execution systems posting compressed transaction data on blockchains) the primary method for handling transactions. The first significant step towards this goal was introducing blob transactions that are designed to meet the data availability needs of such layer 2 protocols. This work constitutes the first rigorous and comprehensive empirical analysis of transaction- and mempool-level data since the institution of blobs on Ethereum on March 13, 2024. We perform a longitudinal study of the blob fee market analyzing the landscape and the behaviors of its participants. We identify and measure the inefficiencies arising out of suboptimal block packing, showing that at times it has resulted in up to 70% relative fee loss. We hone in and give further insight into two (congested) peak demand periods for blobs. Finally, we document a market design issue relating to subset bidding due to the inflexibility of the transaction structure on packing data as blobs and suggest possible ways to fix it. The latter market structure issue also applies more generally on any blockchain that has discrete objects included within transactions.

On the Viability of Open-Source Financial Rails: Economic Security of Permissionless Consensus

Speaker: Jacob Leshno (University of Chicago, Booth)

Bitcoin demonstrated the possibility of a financial rail with a novel economic structure that circumvents monopoly and antitrust concerns. However, questions remain as to whether this open structure can satisfy the security requirements of mainstream financial applications. This paper investigates the underlying consensus protocols to determine whether they can deliver a financial rail that is both open and secure. We answer affirmatively by constructing a protocol that provides an economically meaningful security guarantee while also preserving Bitcoin’s permissionless and open design. Notably, our protocol’s security does not rely on monetary payments to miners or high energy consumption, which our analysis indicates are ineffective. Our framework integrates economic theory with distributed systems theory and formalizes the role of the user community.