Liquidity Misallocation on Decentralized Exchanges

53 Pages Posted: 22 Nov 2022 Last revised: 26 Feb 2024

Date Written: February 1, 2024

Abstract

I find misallocation of capital across liquidity pools on blockchain-based decentral- ized exchanges. Pools with higher (lower) returns the week before continue to yield higher (lower) returns the week after, which average at 33% per annum and cannot be explained by common risk factors, idiosyncratic volatility or transaction costs. 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 impermanent losses – the part of return that is often implicit. Aggregate liquidity on decentralized exchanges would have shrunk by at least $3 billion and abnormal liquidity returns would have decreased by half, if LPs were equally sensitive to implicit impermanent losses.

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

Suggested Citation

Fang, Chuck, Liquidity Misallocation on Decentralized Exchanges (February 1, 2024). 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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