Blockchain Scaling and Liquidity Concentration on Decentralized Exchanges

Abstract

Liquidity providers (LPs) on decentralized exchanges (DEXs) can protect themselves from adverse selection risk by updating their positions more frequently. However, repositioning is costly, because LPs have to pay gas fees for each update. We analyze the causal relation between repositioning and liquidity concentration around the market price, using the entry of a blockchain scaling solution, Polygon, as our instrument. Polygon's lower gas fees allow LPs to update more frequently than on Ethereum. Our results demonstrate that higher repositioning intensity and precision lead to greater liquidity concentration, which benefits small trades by reducing their slippage.

Keywords: decentralized exchanges, FinTech, gas fees, liquidity concentration, market depth, slippage

JEL Classification: G14, G18, G19