What Drives Liquidity on Decentralized Exchanges? Evidence from the Uniswap Protocol

TL;DR

This paper investigates the factors influencing liquidity on decentralized exchanges, introducing a new metric to analyze liquidity concentration and examining how various external and internal factors impact market depth.

Contribution

It introduces the v2 counterfactual spread metric to measure liquidity concentration and decomposes factors affecting liquidity into TVL and concentration channels.

Findings

Gas prices, returns, and trading volume share influence liquidity via concentration.

Private market makers impact TVL but not overall market depth.

Volatility, fees, and markout affect liquidity through both channels.

Abstract

We study liquidity on decentralized exchanges (DEXs), identifying factors at the platform, blockchain, token pair, and liquidity pool levels with predictive power for market depth metrics. We introduce the v2 counterfactual spread metric, a novel criterion which assesses the degree of liquidity concentration in pools using the ``concentrated liquidity'' mechanism, allowing us to decompose the effect of a factor on market depth into two channels: total value locked (TVL) and concentration. We further explore how external liquidity from competing DEXs and private inventory on DEX aggregators influence market depth. We find that (i) gas prices, returns, and a DEX's share of trading volume affect liquidity through concentration, (ii) internalization of order flow by private market makers affects TVL but not the overall market depth, and (iii) volatility, fee revenue, and markout affect liquidity through both channels.