Learning from DeFi: Would Automated Market Makers Improve Equity Trading?

We investigate the potential for automated market makers (AMMs) to be economically viable in and improve traditional financial markets. AMMs are a new type of trading institution that have emerged in the world of crypto-assets and process a significant portion of global crypto trading volume. The current trend of tokenizing assets, the legitimization of crypto-token issuance via the EU's MiCA regulation, and the push by the S.E.C. to change the trading of retail orders present an opportunity to consider AMMs for traditional markets. We develop a theoretical approach for AMM liquidity provision in equities and then calibrate the model parameters based on U.S. equity trading data. Our analysis suggests that optimally designed AMMs could save U.S. investors billions in transaction costs each year. The source for these savings is twofold: AMMs allow better risk sharing for liquidity providers, and they use locked-up capital that otherwise sits idly at brokerages. The savings arise across the board and would particularly improve the liquidity and trading costs for small firms, allowing them to attract more investors and capital.