Behavior of Liquidity Providers in Decentralized Exchanges

TL;DR

This paper investigates how liquidity providers in decentralized exchanges like Uniswap react to market information, their investment strategies, and the associated risks and returns across different trading pair categories.

Contribution

It is the first systematic study analyzing liquidity providers' behavior, strategies, and risk-return profiles in decentralized exchanges.

Findings

Liquidity providers adjust strategies based on market changes.

Returns and risks vary across stable, normal, and exotic pairs.

Liquidity movement between pools is influenced by market dynamics.

Abstract

Decentralized exchanges (DEXes) have introduced an innovative trading mechanism, where it is not necessary to match buy-orders and sell-orders to execute a trade. DEXes execute each trade individually, and the exchange rate is automatically determined by the ratio of assets reserved in the market. Therefore, apart from trading, financial players can also liquidity providers, benefiting from transaction fees from trades executed in DEXes. Although liquidity providers are essential for the functionality of DEXes, it is not clear how liquidity providers behave in such markets. In this paper, we aim to understand how liquidity providers react to market information and how they benefit from providing liquidity in DEXes. We measure the operations of liquidity providers on Uniswap and analyze how they determine their investment strategy based on market changes. We also reveal their returns and risks of investments in different trading pair categories, i.e., stable pairs, normal pairs, and exotic pairs. Further, we investigate the movement of liquidity between trading pools. To the best of our knowledge, this is the first work that systematically studies the behavior of liquidity providers in DEXes.