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Toxicity-Competitiveness Trade-off in Concentrated Liquidity Provision

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  • Aoyagi, Jun
  • Ip, Wang-Hei
  • Kawaguchi, Kohei
  • Kuramoto, Wataru
  • Tsuchida, Shinya

Abstract

Decentralized exchanges (DEXs) adopt automated market makers (AMM) as an alternative to the traditional limit-order book (LOB), which is too costly to implement with blockchain technology. To protect liquidity providers (LPs) against toxic trades by arbitrageurs, Uniswap v3, the leading DEX, has introduced a concentrated liquidity mechanism that allows LPs to restrict the price range accepting trades. We define a liquidity provision game of this setting and characterize the optimal strategy and equilibrium liquidity allocation. We demonstrate that LP profits consist of the competitive and non-competitive parts. Crucially, the non-competitive components arise from toxic trades by arbitrageurs. Consequently, liquidity provision involves a toxicity-competitiveness tradeoff as opposed to the literature understanding them as two independent factors. By incorporating this tradeoff, we derive a novel guideline and implications for liquidity provision in the decentralized financial market.

Suggested Citation

  • Aoyagi, Jun & Ip, Wang-Hei & Kawaguchi, Kohei & Kuramoto, Wataru & Tsuchida, Shinya, 2024. "Toxicity-Competitiveness Trade-off in Concentrated Liquidity Provision," SocArXiv dvuxw, Center for Open Science.
    • Handle: RePEc:osf:socarx:dvuxw
    DOI: 10.31219/osf.io/dvuxw
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    References listed on IDEAS

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    1. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
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