[Paper Review] Behavior of Liquidity Providers in Decentralized Exchanges

Lioba Heimbach, Ye Wang+1 more|arXiv (Cornell University)|May 28, 2021

Economic theories and models11 references29 citations

TL;DR

The paper empirically analyzes liquidity providers on Uniswap, detailing their pool participation, returns, risks across pool types (stable, normal, exotic), and how liquidity moves between pools under external factors like liquidity mining.

ABSTRACT

Decentralized exchanges (DEXes) have introduced an innovative trading mechanism, where it is not necessary to match buy-orders and sell-orders to execute a trade. DEXes execute each trade individually, and the exchange rate is automatically determined by the ratio of assets reserved in the market. Therefore, apart from trading, financial players can also liquidity providers, benefiting from transaction fees from trades executed in DEXes. Although liquidity providers are essential for the functionality of DEXes, it is not clear how liquidity providers behave in such markets. In this paper, we aim to understand how liquidity providers react to market information and how they benefit from providing liquidity in DEXes. We measure the operations of liquidity providers on Uniswap and analyze how they determine their investment strategy based on market changes. We also reveal their returns and risks of investments in different trading pair categories, i.e., stable pairs, normal pairs, and exotic pairs. Further, we investigate the movement of liquidity between trading pools. To the best of our knowledge, this is the first work that systematically studies the behavior of liquidity providers in DEXes.

Motivation & Objective

• Characterize who provides liquidity on Uniswap and how they allocate across pools.
• Quantify returns, risks, and impermanent loss for different pool categories (stable, normal, exotic).
• Investigate how liquidity providers move assets between pools and respond to market factors and external incentives.

Proposed method

• Collect and process Ethereum blockchain data from Uniswap V2 (May 2020–Jan 2021).
• Identify Mint, Burn, and Transfer events to infer liquidity provider balances per pool.
• Classify pools into three categories: stable, normal, exotic, and analyze returns and risks per category.
• Compute returns with respect to a baseline hold/constant-mix portfolio and quantify impermanent loss.
• Evaluate correlations between pool liquidity, volume, and token prices across pools.

Experimental results

Research questions

• RQ1 How are liquidity providers distributed across Uniswap pools and how concentrated is liquidity?
• RQ2 What are the returns and risks (including impermanent loss) for liquidity providers in stable, normal, and exotic pools?
• RQ3 Do liquidity providers move funds between pools in response to market indicators or external incentives like liquidity mining?

Key findings

• Most liquidity is concentrated in a small set of pools; over 60% of liquidity sits in the top 24 pools as of Jan 2021.
• Many providers hold liquidity in a single pool, and the largest providers control substantial liquidity in popular pools.
• Stable pools offer near risk-free, positive returns driven mainly by fees due to negligible impermanent loss.
• Exotic pools show high volatility and significant impermanent loss, making them unattractive for liquidity providers.
• Liquidity distribution patterns show high correlation between injections and withdrawals, indicating gradual market growth and selective pool allocation.
• Movement of liquidity between pools is present but not uniform, with external factors like liquidity mining influencing redistribution.