Conference Agenda

Off-exchange trades are often executed by referencing on-exchange prices. In equilibrium, such price referencing softens market makers' on-exchange competition and makes liquidity expensive for investors. Additionally, by equalizing on- and off-exchange prices, price referencing guarantees “best-execution” and makes investors indifferent where to trade. Market makers effectively obtain a license to fragment order flow off exchange, raising their profits but reinforcing market-wide illiquidity. This inefficiency remains tenacious even if more market makers enter and if they are forced to compete off exchange, as in the SEC's proposed order-by-order auction. The model yields important implications for regulating various forms of off-exchange trading.

We explore the potential for automated market makers (AMMs) to enhance traditional financial markets, drawing on their success in the crypto-assets space. The increasing tokenization of assets and regulatory changes, including the SEC’s initiatives to reshape retail order trading, underscore the relevance of considering AMMs in traditional markets. Our study establishes a practical framework to evaluate the viability of AMM liquidity provision in equities and assess if AMMs offer improvements over traditional markets. Analyzing U.S. equity trading data, we find that well-designed AMMs could save U.S. investors billions annually. These savings arise from the distinct characteristics of AMMs, especially the improved risk-sharing and the role of long-term asset holders as liquidity providers. Unlike traditional market makers, long-term asset holders in AMMs seek compensation only for incremental intraday risk relative to a buy-and-hold strategy. They utilize locked-up capital that would otherwise remain idle at brokerages. Small firms, in particular, can benefit by attracting more investors and capital through this approach.