The Need for Fees at a DEX: How Increases in Fees Can Increase DEX Trading Volume

Abstract

We demonstrate that increasing trading fees at a decentralized exchange (DEX) can increase DEX trading volume. This result arises due to the fact that higher DEX fees can endogenously reduce the price impact of trading at the DEX, thereby reducing the overall DEX trading cost and driving trading activity to the DEX from competing exchanges. The referenced relationship between fees and price impacts arises because DEXs employ a mechanical pricing rule whereby price impacts reduce with the DEX inventory level, and DEXs acquire inventory by offering DEX fee revenue in exchange for capital from investors used to finance the DEX inventory. When fees are sufficiently low, increases in the DEX fee level lead to higher DEX fee revenue and higher DEX investment returns, thereby increasing DEX inventory; in turn, price impacts decline and so too do overall trading costs, resulting in an increase in DEX trading volume.

Keywords: Decentralized Exchange, DEX, Automated Market Makers, AMM

JEL Classification: G10, G12