Fragmentation and optimal liquidity supply on decentralized exchanges

TL;DR

This paper examines how liquidity providers choose between high- and low-fee pools on decentralized exchanges, revealing strategic behaviors and the effects of market fragmentation on liquidity and competition.

Contribution

It provides an empirical analysis of LP behavior and market fragmentation effects on liquidity distribution and provider strategies on Uniswap.

Findings

High-fee pools attract 58% of liquidity but only 21% of volume.

Large LPs prefer low-fee pools and frequently adjust positions.

Small LPs favor high-fee pools to reduce adverse selection.

Abstract

We investigate how liquidity providers (LPs) choose between high- and low-fee trading venues, in the face of a fixed common gas cost. Analyzing Uniswap data, we find that high-fee pools attract 58% of liquidity supply yet execute only 21% of volume. Large LPs dominate low-fee pools, frequently adjusting out-of-range positions in response to informed order flow. In contrast, small LPs converge to high-fee pools, accepting lower execution probabilities to mitigate adverse selection and liquidity management costs. Fragmented liquidity dominates a single-fee market, as it encourages more liquidity providers to enter the market, while fostering LP competition on the low-fee pool.