An Economic Model of a Decentralized Exchange with Concentrated Liquidity

51 Pages Posted: 3 Aug 2023 Last revised: 20 Sep 2023

See all articles by Joel Hasbrouck

Joel Hasbrouck

New York University (NYU) - Department of Finance

Thomas J Rivera

McGill University

Fahad Saleh

University of Florida

Date Written: August 2, 2023

Abstract

We develop an economic model of a decentralized exchange with concentrated liquidity (i.e., Uniswap V3) with a particular focus on the economics of liquidity provision. We demonstrate that providing liquidity for a risky/risk-free asset pool is comparable to investing in a covered call except that the call option therein is sold at intrinsic rather than market value. Hence, when providing liquidity, liquidity providers forgo the time premium of the call option in exchange for fees and thus equilibrium liquidity provision decreases in the time premium. Finally, we provide an expression for equilibrium liquidity provision which is useful for empirical work.

Keywords: Decentralized Exchange, DEX, Automated Market Makers, AMM, Concentrated Liquidity, Uniswap V3

JEL Classification: G10, G12

Suggested Citation

Hasbrouck, Joel and Rivera, Thomas and Saleh, Fahad, An Economic Model of a Decentralized Exchange with Concentrated Liquidity (August 2, 2023). Available at SSRN: https://ssrn.com/abstract=4529513 or http://dx.doi.org/10.2139/ssrn.4529513

Joel Hasbrouck

New York University (NYU) - Department of Finance ( email )

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Thomas Rivera

McGill University ( email )

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Montreal, Quebec h3A 1G5

Fahad Saleh (Contact Author)

University of Florida ( email )

Warrington College of Business
Gainesville, FL 32611
United States

HOME PAGE: http://www.cryptoeconprof.com

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