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Equilibrium Liquidity and Risk Offsetting in Decentralised Markets

Author

Listed:
  • Fayc{c}al Drissi
  • Xuchen Wu
  • Sebastian Jaimungal

Abstract

We study the economic viability of liquidity provision in decentralised exchanges (DEXs) within a structural framework in which market outcomes are endogenous. We formulate strategic interactions as a sequential game: a risk-averse liquidity provider (LP) sets the supply of liquidity in the DEX and a costly dynamic replication strategy in a centralised exchange (CEX), price-sensitive traders determine trading volumes, and arbitrageurs align prices. We establish existence of equilibrium under general trading functions. We show that DEX liquidity depth is a central instrument for risk management, because the LP adjusts liquidity ex ante to manage exposure. In addition to the classical trade-off between liquidity demand and adverse selection, we identify two further determinants of the viability of liquidity provision: the ratio of risk aversion to replication costs and private information. The ratio governs the aggressiveness of replication: greater relative risk aversion reduces risk but also lowers equilibrium liquidity and its mean profitability. Private information has a non-monotonic effect. For moderate price movements, speculative benefits increase liquidity. For large price movements, anticipated adverse selection and replication costs lead to thinner markets.

Suggested Citation

  • Fayc{c}al Drissi & Xuchen Wu & Sebastian Jaimungal, 2025. "Equilibrium Liquidity and Risk Offsetting in Decentralised Markets," Papers 2512.19838, arXiv.org, revised Mar 2026.
    • Handle: RePEc:arx:papers:2512.19838
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    References listed on IDEAS

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