The Conceptual Flaws of Constant Product Automated Market Making

Blockchain-based decentralized exchanges fall into two broad categories: decentralized limit order books where an order is a smart contract registered on the blockchain, and swap exchanges where prices are set by a deterministic automated market-making rule. The most common form of the latter is the constant product rule where relative prices of crypto assets are determined by iso-liquidity curves. Although this pricing rule is simple, its use is conceptually problematic and gives rise to persistent arbitrage opportunities when there are multiple competing trading systems. It also allows intrinsically profitable front-running opportunities. Traditional market maker pricing, on the other hand, does not suffer from these flaws. Empirically, more than 10% of trades incur an excess cost of 7% or more in less liquid trading pairs.