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Risks and Returns of Uniswap V3 Liquidity Providers

Author

Listed:
  • Lioba Heimbach
  • Eric Schertenleib
  • Roger Wattenhofer

Abstract

Trade execution on Decentralized Exchanges (DEXes) is automatic and does not require individual buy and sell orders to be matched. Instead, liquidity aggregated in pools from individual liquidity providers enables trading between cryptocurrencies. The largest DEX measured by trading volume, Uniswap V3, promises a DEX design optimized for capital efficiency. However, Uniswap V3 requires far more decisions from liquidity providers than previous DEX designs. In this work, we develop a theoretical model to illustrate the choices faced by Uniswap V3 liquidity providers and their implications. Our model suggests that providing liquidity on Uniswap V3 is highly complex and requires many considerations from a user. Our supporting data analysis of the risks and returns of real Uniswap V3 liquidity providers underlines that liquidity providing in Uniswap V3 is incredibly complicated, and performances can vary wildly. While there are simple and profitable strategies for liquidity providers in liquidity pools characterized by negligible price volatilities, these strategies only yield modest returns. Instead, significant returns can only be obtained by accepting increased financial risks and at the cost of active management. Thus, providing liquidity has become a game reserved for sophisticated players with the introduction of Uniswap V3, where retail traders do not stand a chance.

Suggested Citation

  • Lioba Heimbach & Eric Schertenleib & Roger Wattenhofer, 2022. "Risks and Returns of Uniswap V3 Liquidity Providers," Papers 2205.08904, arXiv.org, revised Sep 2022.
    • Handle: RePEc:arx:papers:2205.08904
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    References listed on IDEAS

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    1. Lioba Heimbach & Ye Wang & Roger Wattenhofer, 2021. "Behavior of Liquidity Providers in Decentralized Exchanges," Papers 2105.13822, arXiv.org, revised Oct 2021.
    2. Guillermo Angeris & Tarun Chitra, 2020. "Improved Price Oracles: Constant Function Market Makers," Papers 2003.10001, arXiv.org, revised Jun 2020.
    3. Alex Evans & Guillermo Angeris & Tarun Chitra, 2021. "Optimal Fees for Geometric Mean Market Makers," Papers 2104.00446, arXiv.org.
    4. Robin Fritsch, 2021. "Concentrated Liquidity in Automated Market Makers," Papers 2110.01368, arXiv.org.
    5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    6. Alex Evans, 2020. "Liquidity Provider Returns in Geometric Mean Markets," Papers 2006.08806, arXiv.org, revised Jul 2020.
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. 'Alvaro Cartea & Fayc{c}al Drissi & Marcello Monga, 2023. "Decentralised Finance and Automated Market Making: Predictable Loss and Optimal Liquidity Provision," Papers 2309.08431, arXiv.org, revised Jun 2024.
    2. Matheus V. X. Ferreira & David C. Parkes, 2022. "Credible Decentralized Exchange Design via Verifiable Sequencing Rules," Papers 2209.15569, arXiv.org, revised Apr 2023.
    3. Alfred Lehar & Christine Parlour & Marius Zoican, 2023. "Fragmentation and optimal liquidity supply on decentralized exchanges," Papers 2307.13772, arXiv.org, revised May 2024.
    4. Tristan Lim, 2022. "Predictive Crypto-Asset Automated Market Making Architecture for Decentralized Finance using Deep Reinforcement Learning," Papers 2211.01346, arXiv.org, revised Jan 2023.
    5. Tristan Lim, 2024. "Predictive crypto-asset automated market maker architecture for decentralized finance using deep reinforcement learning," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 10(1), pages 1-29, December.
    6. Basile Caparros & Amit Chaudhary & Olga Klein, 2023. "Blockchain scaling and liquidity concentration on decentralized exchanges," Papers 2306.17742, arXiv.org, revised Mar 2024.
    7. Marcello Monga, 2024. "Automated Market Making and Decentralized Finance," Papers 2407.16885, arXiv.org.
    8. Deborah Miori & Mihai Cucuringu, 2022. "DeFi: data-driven characterisation of Uniswap v3 ecosystem & an ideal crypto law for liquidity pools," Papers 2301.13009, arXiv.org, revised Jan 2023.

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