Introduction & Background 

The business of market making and financial market infrastructure is a lucrative one often critical to banks’ income statements. Since 1986, exchanges like the London Stock Exchange have used an electronic order book to match buyers with sellers and facilitate trades, known as a Central Limit Order Book (CLOB). Today, banks make hundreds of millions of dollars each year profiting from the difference between bids and asks on these exchanges, a practice known as market making. Recently however, decentralised finance (DeFi) (the practice of enabling new financial technology through the use of a blockchain) has been gaining momentum, with a 49% CAGR. This has surfaced a new question: is the order book really the best way to facilitate trading?  

As of today, high frequency trading firms are gaining larger swathes of the market making landscape, capturing up to 80% of CLOB market making volumes in the digital asset market, for example. Whilst this may have made markets more economically efficient, it has led to tougher market making conditions for banks in recent history. Automated Market Makers (AMMs) may offer an opportunity to beat the market and access liquidity more easily, but would require a significant move away from existing banking infrastructure.  

Whilst DeFi has been mired with scams and collapses over the years, the fundamental technology has remained, and out of it the AMM has emerged. Initially designed to enable users to trade digital assets before their listing on traditional exchanges, AMMs sought to harness blockchain technology to facilitate trading without a centralized intermediary. But how could traders ensure they were paying or receiving a fair market price? And how could they be certain that the assets they traded for would be securely transferred—without relying solely on trust in their counterparty? Today, the technology has evolved far beyond this, and has realised a number of other benefits. 

Market making has long been unchallenged due to the complex infrastructure, legacy technologies and the costs incurred to set-up a new way of managing liquidity. Herein we look at the benefits of AMMs and how early adopters can capitalize on their increased price stability and better access to liquidity. Critically, now more than ever, a US administration signalling deregulation could provide significant tailwinds for banks entering this space. By reducing the regulatory scrutiny on digital assets and financial engineering seen under previous administrations, it would allow firms to capitalize on the benefits of DeFi. 

What is an AMM and how does it differ from an order book? 

An AMM is effectively a pool of proportionate quantities of two assets, sitting on a blockchain, which delivers the liquidity for trades to be made. For example, to enable traders to trade gold for USD (and vice versa), the pool would be made up of proportional quantities of gold and USD, and traders would add USD to the pool to buy gold, or add gold to the pool to sell it for USD.  

Whilst order books rely on market makers looking to profit from bid-ask spreads to provide liquidity, AMMs instead draw upon the liquidity held within the pool to facilitate a trade. If using an exchange with a CLOB, a trader is reliant on a counterparty filling his bid or ask, and most of the time this counterparty is one of a small number of market makers. In an AMM system, the trader can instead simply tap the assets held in the pool to make their trade. The blockchains that AMMs operate on eliminate the need for a central intermediary to match orders and facilitate asset transfers. This ensures that traders do not have to rely on an intermediary or counterparty, thereby reducing counterparty risk. 

 Unlike order books, AMMs are entirely algorithm-driven and rely on mathematical functions to calculate the quantities of each asset in the pool, ensuring balance. They are fundamentally based on the principle that the cumulative reserves of both assets must remain constant. In doing so, AMMs not only ensure liquidity on both sides of a trade but also algorithmically determine the market price of an asset. Prices increase as traders buy assets from the pool and decrease as they sell assets into it, without relying on the convergence of bids and asks to establish a market price. 

For banks, this means getting the best price, and being able to execute at this price quickly and efficiently, without relying on a counterparty and a centralised exchange for liquidity and execution. We have already seen the importance of pricing and execution speed to banks manifest in the rise of electronic trading, with more than 85% of FX spot volume for example, being electronically traded today. AMMs offer an opportunity to further optimize the gains realized from electronic trading, but have a number of pros and cons which we will continue to explore in part two. 

Conclusion 

Market making has already undergone a drastic transformation with the rise of electronic trading and high-frequency trading firms. By examining the functionality of AMMs, we can see that they may represent the next phase of this evolution, offering algorithmic pricing and optimized liquidity in digital asset markets. In the next part of this series, we will delve deeper into the pros and cons of AMMs and address a key question: what does this mean for banks in the future, and how might AMMs generate revenue? 

Read part 2