[Today’s Signal] Does an AMM-Based DEX Discover Prices—or Follow the Market?

Decentralized exchanges (DEXs) operate without a central intermediary, with their pricing mechanism fundamentally different from traditional exchanges. Automated Market Maker (AMM) DEXs, like Uniswap, determine exchange rates through smart contracts and the balance of assets in liquidity pools, rather than through competition between buy and sell orders.

Professor Hyoung Joong Kim of Kookmin University, a well-known researcher in cryptography, blockchain and digital assets, has identified a key market question: while AMMs have limited price discovery ability, they excel at tracking prices set elsewhere.

When an AMM's internal price diverges from the broader market, arbitrageurs step in to trade and narrow the gap. Part of the price-setting process moves from competition among traders to an interaction between mathematical rules and arbitrage incentives.

AMMs provide an initial pricing venue for long-tail assets with limited activity in established order books. However, they should be assessed not by their price discovery capabilities but by their ability to maintain market operations. Uniswap's early design relies on the constant-product formula (x * y = k), where x and y represent asset quantities in a liquidity pool.

When a trader adds or removes an asset, the pool's balance changes, and the exchange price adjusts accordingly. The AMM doesn't simply import external market prices; instead, arbitrageurs buy ETH at a lower price in the pool and sell it at a higher external price, adjusting the pool's asset balance and bringing the AMM price closer to the market.

For widely traded assets like ETH, reference prices are often established in more liquid venues first, with arbitrage transmitting those prices into on-chain pools. For newly issued or long-tail tokens without active order books, AMMs may become crucial for initial price formation. AMMs' functions vary depending on the asset and market, sometimes helping discover prices and other times following prices set elsewhere.

BIS analysis highlights that relative prices in AMMs depend on the quantities of assets in their liquidity pools. While arbitrage can correct external market deviations, liquidity providers might fare worse than holding the appreciating asset outside the pool. Uniswap's concentrated liquidity model improves capital efficiency by allowing liquidity providers to allocate capital within a specific price range.

However, it also introduces management risks, as positions can become inactive or overly exposed to a single asset if the market price moves outside the chosen range.