Aggregation of financial markets

Abstract

We present a formal framework for the aggregation of financial markets mediated by arbitrage. Our main tool is to characterize markets via utility functions and to employ a one-to-one correspondence to limit order book states. Inspired by the theory of thermodynamics, we argue that the arbitrage-mediated aggregation mechanism gives rise to a market-dynamical entropy, which quantifies the loss of liquidity caused by aggregation. As a concrete guiding example, we illustrate our general approach with the Uniswap v2 automated market maker protocol used in decentralized cryptocurrency exchanges, which we characterize as a so-called ideal market. We derive its equivalent limit order book representation and explicitly compute the arbitrage-mediated aggregation of two liquidity pools of the same asset pair with different marginal prices. We also discuss future directions of research in this emerging theory of market dynamics.