Decentralised dealers? Examining liquidity provision in decentralised exchanges

Summary

Focus

We explore the role of sophisticated and unsophisticated participants in providing liquidity on decentralised exchanges (DEXs), focusing on Uniswap V3, one of the largest DEX platforms. By analysing large data sets of transactions, we identify different strategies used by sophisticated (institutional) and unsophisticated (retail) participants. We categorise participants based on their behaviour and position sizes and assess their profitability, liquidity provision strategies and responses to market changes.

Contribution

Our research goal is to understand whether DEXs fulfil their promise of "democratising" financial markets by allowing anyone to participate in liquidity provision without intermediaries. Our main contribution lies in showing whether DEXs are inclusive or mimic traditional markets, where a few large players dominate. By distinguishing between sophisticated and unsophisticated participants, we add to the growing literature on decentralised finance and market structure.

Findings

We show that liquidity provision on DEXs is concentrated among a small, skilled group of sophisticated (institutional) participants rather than a broad, diverse set of users. These participants submit orders that mimic traditional bid-ask spreads, enabling them to earn significantly higher profits – both in absolute and relative terms – compared with their unsophisticated (retail) counterparts. They also exhibit considerable skill, capturing a larger share of trades and higher profits, especially during periods of high market volatility. This concentration suggests that, despite the decentralised nature of DEXs, sophisticated participants dominate liquidity provision, limiting the extent to which DEXs democratise market access.

Abstract

Decentralised exchanges allow participants to buy and sell assets without the need for intermediaries, in theory democratising liquidity provision. However, using data from the largest decentralised exchange, we show that liquidity provision – rather than being the purview of a diffused set of market participants – is instead confined predominantly to a small group o f sophisticated ones. These participants submit orders that mimic bids and asks and are able to extract significantly higher profits (both in absolute and relative terms) compared to their unsophisticated counterparts. They also exhibit considerable skill, extracting higher profits during periods of high volatility by capturing a higher share of trading without incurring additional adverse selection.

JEL classification: D47, G14, G23

Keywords: market design, market making, liquidity, automated market maker, decentralised finance