Liquidity Provision on Blockchain-based Decentralized Exchanges

Abstract

We show that the existing infrastructure of decentralized exchanges exposes liquidity providers to arbitrage losses, raising the costs of liquidity provision. Arbitrage rents are extracted by validators as infrastructure fees. Design changes such as speed priority, modified order sequencing rules, flexible pricing curves, and multi-token pools have limited effectiveness in reducing these rents. Using the Silicon Valley Bank collapse as an exogenous shock, we provide empirical support to the negative effects of arbitrageurs on liquidity provision and to the liquidity providers’ offer of wider price ranges to mitigate rent extraction. The median arbitrageur passes 97% of their profits to validators.

Keywords: Decentralized Finance (DeFi), Market Microstructure, automated market maker, tokenomics

JEL Classification: G14, G19