Blockchain scaling and liquidity concentration on decentralized exchanges

TL;DR

This paper investigates how reduced transaction costs on blockchain scaling solutions like Arbitrum and Polygon enable liquidity providers on decentralized exchanges to reposition more frequently, leading to increased liquidity concentration and improved trading conditions for small traders.

Contribution

It provides causal evidence that lower gas fees from blockchain scaling solutions increase LP repositioning, enhancing liquidity concentration and reducing slippage for small trades.

Findings

Lower gas fees increase LP repositioning frequency.

Increased repositioning leads to higher liquidity concentration.

Greater liquidity concentration benefits small traders by reducing slippage.

Abstract

Liquidity providers (LPs) on decentralized exchanges (DEXs) can protect themselves from adverse selection risk by updating their positions more frequently. However, repositioning is costly, because LPs have to pay gas fees for each update. We analyze the causal relation between repositioning and liquidity concentration around the market price, using the entry of blockchain scaling solutions, Arbitrum and Polygon, as our instruments. Lower gas fees on scaling solutions allow LPs to update more frequently than on Ethereum. Our results demonstrate that higher repositioning intensity and precision lead to greater liquidity concentration, which benefits small trades by reducing their slippage.