Inefficiency of CFMs: hedging perspective and agent-based simulations

TL;DR

This paper examines whether fee income from Centralized Funding Markets (CFMs) adequately compensates liquidity providers for market risk, using mathematical analysis and agent-based simulations, and finds it generally insufficient.

Contribution

It combines financial mathematics and agent-based simulations to assess CFM efficiency and liquidity provider compensation, revealing systemic inefficiencies.

Findings

Fee income often insufficient to hedge market risk

CFM inefficiency persists across various market conditions

Agent simulations support mathematical analysis results

Abstract

We investigate whether the fee income from trades on the CFM is sufficient for the liquidity providers to hedge away the exposure to market risk. We first analyse this problem through the lens of continuous-time financial mathematics and derive an upper bound for not-arbitrage fee income that would make CFM efficient and liquidity provision fair. We then evaluate our findings by performing multi-agent simulations by varying CFM fees, market volatility, and rate of arrival of liquidity takers. We observe that, on average, fee income generated from liquidity provision is insufficient to compensate for market risk.