The Paradox of Just-in-Time Liquidity in Decentralized Exchanges: More Providers Can Lead to Less Liquidity

63 Pages Posted: 7 Dec 2023 Last revised: 5 Apr 2024

See all articles by Agostino Capponi

Agostino Capponi

Columbia University - Department of Industrial Engineering and Operations Research

Ruizhe Jia

Columbia University

Brian Zhu

Columbia University - Department of Industrial Engineering and Operations Research

Date Written: March 14, 2024

Abstract

We study Just-in-time (JIT) liquidity provision in blockchain-based decentralized exchanges. A JIT liquidity provider (LP) monitors pending swap orders in public mempools of blockchains to sandwich swaps of their choice with liquidity, depositing right before and withdrawing right after the swap. Our game-theoretic model with asymmetrically informed agents reveals that the presence of a JIT LP does not necessarily enhance liquidity pool depth. While passive LPs face adverse selection from informed arbitrageurs, a JIT LP can detect pending orders for toxic order flow prior to liquidity provision. This second-mover advantage mitigates a JIT LP's adverse selection costs and could lead to the crowding out of passive LPs when order flows are not very sensitive to changes in pool depth, reducing overall market liquidity. We show that the detrimental effects of JIT liquidity can be alleviated by using a two-tiered fee structure which transfers a proportion of a JIT LP's fee revenue to passive LPs or by allowing JIT LPs to compete over deposit quantity.

Keywords: just-in-time liquidity, decentralized exchanges, liquidity provision, automated market making, market microstructure, high-frequency market making

JEL Classification: G1, G2

Suggested Citation

Capponi, Agostino and JIA, RUIZHE and Zhu, Brian, The Paradox of Just-in-Time Liquidity in Decentralized Exchanges: More Providers Can Lead to Less Liquidity (March 14, 2024). Available at SSRN: https://ssrn.com/abstract=4648055 or http://dx.doi.org/10.2139/ssrn.4648055

Agostino Capponi (Contact Author)

Columbia University - Department of Industrial Engineering and Operations Research ( email )

RUIZHE JIA

Columbia University ( email )

3022 Broadway
New York, NY 10027
United States

Brian Zhu

Columbia University - Department of Industrial Engineering and Operations Research ( email )

500 W. 120th Street #315
New York, NY 10027
United States

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