am-AMM: An Auction-Managed Automated Market Maker (2403.03367v4)

Abstract: Automated market makers (AMMs) have emerged as the dominant market mechanism for trading on decentralized exchanges implemented on blockchains. This paper presents a single mechanism that targets two important unsolved problems for AMMs: reducing losses to informed orderflow, and maximizing revenue from uninformed orderflow. The auction-managed AMM'' works by running a censorship-resistant onchain auction for the right to temporarily act aspool manager'' for a constant-product AMM. The pool manager sets the swap fee rate on the pool, and also receives the accrued fees from swaps. The pool manager can exclusively capture some arbitrage by trading against the pool in response to small price movements, and also can set swap fees incorporating price sensitivity of retail orderflow and adapting to changing market conditions, with the benefits from both ultimately accruing to liquidity providers. Liquidity providers can enter and exit the pool freely in response to changing rent, though they must pay a small fee on withdrawal. We prove that under certain assumptions, this AMM should have higher liquidity in equilibrium than any standard, fixed-fee AMM.

• The paper presents an auction-managed AMM that minimizes arbitrage losses by dynamically optimizing swap fees.
• It employs a Harberger lease-based on-chain auction to select a pool manager with adaptive fee-setting and arbitrage capture.
• Analytical results show that the am-AMM attracts higher liquidity equilibrium than fixed-fee AMMs by effectively transferring risk to informed managers.

am-AMM: An Auction-Managed Automated Market Maker

The paper "am-AMM: An Auction-Managed Automated Market Maker" explores the innovative design of an Automated Market Maker (AMM) mechanism aimed at addressing two pivotal challenges in decentralized financial markets: reducing losses to informed order flow and maximizing revenue from uninformed order flow. The authors propose an auction-managed AMM (am-AMM) which dynamically adjusts to market conditions via a censorship-resistant on-chain auction mechanism.

Key Concepts and Mechanisms

In traditional AMM designs, such as those operating on blockchain-based decentralized exchanges (DEXs), fixed trading fees are used to balance between revenue generation from uninformed retail flows and losses incurred due to arbitrage activities. These fixed-fee AMMs (ff-AMMs) require liquidity providers (LPs) to choose pools with predefined fee rates, which can lead to inefficiencies and fragmentation of liquidity.

The am-AMM introduced in this paper addresses these inefficiencies through a novel mechanism that assigns the role of a pool manager to the highest bidder in an ongoing on-chain auction. The pool manager gains the right to set swap fees dynamically and earns all accrued fees from trades. This setup allows the pool manager to:

• Capture small arbitrage opportunities: The manager can trade against the pool with minimal costs, acting promptly on slight price deviations.
• Optimize swap fees: Adjust fees based on market conditions and the price sensitivity of retail flows, thereby ensuring that fees are optimal and adapt to changing market dynamics.

Auction Mechanics

The auction for pool management operates as a "Harberger lease," where interested participants bid to become the pool manager based on a per-block rent model. Key elements include:

• Bid Parameters: Bids are expressed in terms of rent per block and must include a deposit covering at least a specified minimum duration.
• Censorship Resistance: The auction's delayed activation mechanism ensures robustness against censorship attempts within the blockchain.
• Manager's Rights: The manager can set fees and trade with minimal penalties, maximizing their ability to capture arbitrage profits and adjust to retail flow dynamics.
• Rent Distribution: Liquidity providers receive rent payments from the manager, proportional to their liquidity share in the pool.

Analytical Results

The paper provides a rigorous theoretical framework to demonstrate the advantages of the am-AMM mechanism. Under certain assumptions, such as those regarding noise trader demand and arbitrage profits, the authors prove that the am-AMM will attract more liquidity in equilibrium compared to any fixed-fee AMM. Key theoretical insights include:

• Liquidity Attraction: The equilibrium liquidity in the am-AMM is higher than in ff-AMMs due to the dynamic fee optimization and rent payments that reflect expected revenue from uninformed order flow.
• Risk Transfer: By shifting the responsibility of managing fee settings and arbitrage from passive liquidity providers to active, sophisticated pool managers, the model potentially reduces the overall risk for LPs and improves market efficiency.

Implications and Future Directions

The proposed am-AMM model fundamentally changes the interaction between liquidity providers and the AMM mechanism, potentially setting new standards for efficiency and adaptability in decentralized markets. However, several implications and limitations necessitate further exploration:

• Sandwich Attacks: The manager's ability to trade with near-zero fees may exacerbate sandwich attacks, where public transactions are pushed to their limit prices. Mitigations could include private relays or verifiable sequencing rules.
• Block Builder Market: The exclusive right to capture arbitrage profits could have unintended consequences on block builder markets, possibly centralizing power among sophisticated entities.
• Extending to Other AMMs: While the current model focuses on constant product AMMs, extending this dynamic auction mechanism to concentrated liquidity AMMs or other variations poses an interesting avenue for future research.

In conclusion, the am-AMM presents a compelling innovation in the design of AMM mechanisms for decentralized exchanges. By leveraging an auction-based approach to dynamically adjust trading fees and optimize arbitrage opportunities, it holds the promise of enhancing liquidity and market efficiency while also setting the stage for further advancements in decentralized financial systems. Future work in this area should focus on practical implementations, empirical validations, and exploring extensions to other types of automated market makers.