Decentralized Exchanges: The Profitability Frontier of Constant Product Market Makers

TL;DR

This paper investigates the profitability conditions of constant product market makers like Uniswap V2, introducing the profitability frontier concept, analyzing fee impacts, and empirically validating theoretical models with extensive transaction data.

Contribution

It formalizes liquidity providers' profitability conditions, introduces the profitability frontier in xyk-space, and combines theoretical analysis with empirical data from Uniswap V2.

Findings

Profitability is heavily influenced by mint and burn fees.

The profitability frontier varies with pool types and trading pair characteristics.

Empirical data supports the theoretical framework and profitability conditions.

Abstract

In this paper we analyze constant product market makers (CPMMs). We formalize the liquidity providers' profitability conditions and introduce a concept we call the profitability frontier in the xyk-space. We study the effect of mint and burn fees on the profitability frontier, consider various pool types, and compile a large data set from all Uniswap V2 transactions. We use this data to further study our theoretical framework and the profitability conditions. We show how the profitability of liquidity provision is severely affected by the costs of mint and burn events relative to the portfolio size and the characteristics of the trading pair.