Liquidity and systemic risks in centralized and decentralized markets

Funded by the European Union - NextGenerationEU under the National Recovery and Resilience Plan (PNRR) - Mission 4 Education and research - Component 2 From research to business - Investment 1.1 Notice Prin 2022 - DD N. 104 del 2/2/2022

Technological progress and digitalization have always affected the way markets are organized and trading takes place. In very recent years a potentially breakthrough advancement has been brought by blockchain technology. In particular, Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers, which makes it possible to exchange financial products without the need of intermediaries or organized exchanges. The use of decentralized exchanges is nowadays mostly limited to the exchange of cryptocurrency, but it is foreseeable that its use might also revolutionize the exchange and trading activity of more traditional asset classes. While decentralized markets represent an intriguing development of market structure, the implications of the new structure for the role of information in the price discovery process, the measurement, control, and determinants of liquidity and transactions costs, as well as the implications for the efficiency, welfare, and how markets should be designed have not yet been sufficiently explored. Moreover, the systemic implications of the adoption of DeFi and in general of unregulated exchanges are not understood, but are clearly extremely important. The Financial Stability Board has very recently issued a document highlighting the importance of the assessment of risks to financial stability from crypto-assets and DeFi.

The aim of this research project is to contribute to fill the gap in the understanding of the market microstructure of decentralized exchanges and of the channels of propagation systemic risk brought by this new technology. This will be done by performing a strict comparison of centralized (CEX) and decentralized exchange (DEX), with the aim of highlighting the specificity of DeFi. In some cases the comparison will consider the same asset (e.g. a crypto-currency exchange rate) traded in centralized and decentralized exchanges, while in others we will consider the comparison across different asset classes. We will consider analytical and computational models of different market structures. As an important example of regulation analysis we will investigate the role of tick size, its optimal dimension both for a single asset and across different securities. We then consider economic and econometric models to understand and quantify systemic in crypto markets as well as risk spill-overs from crypto markets to core financial markets.
Moreover, an objective of this research project is an empirical and model-based reassessment of traditional risk-mitigation and regulation approaches that have traditionally characterized financial securities trade and regulation. New emerging business models originated by the so-called ‘Fintech Revolution’ will require new analysis and regulation methods to safeguard investor protection from systemic and liquidity risks and guarantee that financial markets foster equitable and sustainable long-term economic growth.

The project is composed by two units:  (1) University of Bologna, headed by prof. Fabrizio Lillo (PI of the project) and (2) Università Commerciale "Luigi Bocconi" headed by prof. Claudio Tebaldi