Liquidity Fragmentation on Decentralized Exchanges
48 Pages Posted: 17 Nov 2022
Date Written: November 14, 2022
Liquidity providers (LPs) on decentralized exchanges pay a fixed transaction cost (gas price) whenever they update their positions. Different economies of scale across LPs lead in equilibrium to the fragmentation of liquidity supply between low- and high-fee pools. Using data on liquidity updates from Uniswap, we document that while high-fee pools attract 56% of liquidity supply, they only execute 35% of trading volume. Low-fee pools cater to large (institutional) LPs, who update positions frequently in response to large trading volume. In contrast, small (retail) LPs converge to high-fee pools, trading off lower execution probabilities against a smaller liquidity management cost.
Keywords: FinTech, decentralized exchanges (DEX), liquidity, fragmentation
JEL Classification: G11, G12, G14
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