Abstract: In Decentralised Finance, anyone can act as a market maker by providing liquidity to so-called liquidity pools. The exchange mechanism of such a Decentralised Exchange is typically governed by a Geometric Mean Market Maker (“G3M”).
I will discuss how, in the absence of transaction costs, weighted variance swaps can be used to hedge the adverse selection risk that liquidity providers face due to the arbitrage activity required for price discovery within a liquidity pool. When traders are charged transaction fees, liquidity provision approximates constant-weighted portfolio management under relatively mild assumptions, but the exact relationship between the transaction fees charged and the resulting portfolio weights remains to be determined.
If time permits, I will present results on market-neutral liquidity provision in G3Ms with concentrated liquidity and introduce drawdown-constrained liquidity provision.
This is based on joint work with Masaaki Fukasawa (Osaka University) and Basile Maire (Quantena AG).