Liquidity Misallocation on Decentralized Exchanges
51 Pages Posted: 22 Nov 2022 Last revised: 13 Oct 2023
Date Written: September 1, 2023
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
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