Liquidity Misallocation on Decentralized Exchanges

51 Pages Posted: 22 Nov 2022 Last revised: 13 Oct 2023

Date Written: September 1, 2023

Abstract

I find persistent misallocation of capital across liquidity pools on blockchain-based decentralized exchanges. Pools with higher (lower) returns the week before continue to yield higher (lower) returns the week after that average at 39% per annum and cannot be explained by common risk factors, idiosyncratic risks or transaction costs. I argue that this return predictability arises because liquidity providers do not optimally compete away abnormal liquidity returns. Instead, LPs chase fee revenues – the part of return that is saliently marketed as APY – but ignore adverse selection losses – the part of return that is often implicit. Aggregate liquidity on decentralized exchanges would have been at least $3 billion lower if LPs were equally sensitive to implicit adverse selection losses.

Keywords: liquidity provision, automated market makers, decentralized exchanges, DeFi, financial innovation, investor sophistication

Suggested Citation

Fang, Chuck, Liquidity Misallocation on Decentralized Exchanges (September 1, 2023). Jacobs Levy Equity Management Center for Quantitative Financial Research Paper, Available at SSRN: https://ssrn.com/abstract=4281293 or http://dx.doi.org/10.2139/ssrn.4281293

Chuck Fang (Contact Author)

Drexel University ( email )

3141 Chestnut St
Philadelphia, PA 19104
United States

HOME PAGE: http://www.chuckfang.finance

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