[Paper Review] On The Quality Of Cryptocurrency Markets: Centralized Versus Decentralized Exchanges

Andrea Barbon, Angelo Ranaldo|arXiv (Cornell University)|Dec 14, 2021

Blockchain Technology Applications and Security4 citations

TL;DR

This paper compares market quality between centralized (CEXs) and decentralized exchanges (DEXs) in cryptocurrency markets, analyzing transaction costs and price efficiency via the no-arbitrage condition. It finds DEXs now match CEXs in transaction costs due to innovations like Uniswap v3’s DPR and MFT, but still lag in price efficiency due to gas fees, despite a 48% reduction in price deviations post-upgrade.

ABSTRACT

We analyze the market quality of centralized crypto exchanges (CEXs) and decentralized blockchain-based venues (DEXs) using a unique and comprehensive dataset. Focusing on two fundamental aspects, transaction costs and deviations from the no-arbitrage condition, we estimate the causal effect of ``gas fees'' on DEX market quality. We show that these fixed costs impose a significant burden on relatively small trades and cause persistent arbitrage deviations. Conversely, DEXs offer more competitive transaction costs for larger trades, offering a more favorable environment for institutional investors. Furthermore, we provide causal evidence that innovations aimed at enhancing the flexibility of liquidity provision in DEX markets lead to sizeable improvements in market quality.

Motivation & Objective

• To assess and compare the market quality of centralized exchanges (CEXs) and decentralized exchanges (DEXs) in cryptocurrency trading.
• To examine whether DEXs, based on automated market makers (AMMs), can match the efficiency and liquidity of traditional CEXs using limit order books (LOBs).
• To quantify the impact of recent DEX innovations—specifically Uniswap v3’s Discretionary Price Range (DPR) and Multiple Fee Tiering (MFT)—on market quality.
• To evaluate the role of gas fees and exchange fees as frictions undermining DEX price efficiency, especially in triangular arbitrage conditions.
• To provide causal evidence on how structural changes in DEX protocols improve market quality, informing future adoption in traditional finance.

Proposed method

• The study constructs an hour-pair-level panel of transaction costs (exchange fees, bid-ask spreads, gas fees) for DEXs and CEXs around Uniswap v3’s deployment on May 5, 2021.
• It uses a difference-in-differences (DiD) framework to estimate causal effects of Uniswap v3’s upgrade on price efficiency, using CEX metrics as a control group.
• The dependent variable measures absolute deviations from the triangular no-arbitrage condition, capturing price inefficiency across exchange pairs.
• The analysis includes fixed effects for weeks and exchange triplets to control for time-varying confounders and common market factors.
• It evaluates the impact of two key mechanisms: the Discretionary Price Range (DPR), allowing liquidity providers to concentrate capital in specific price ranges, and Multiple Fee Tiering (MFT), enabling multiple fee levels per trading pair.
• The study leverages a quasi-natural experiment following the FTX collapse to assess causal effects on price efficiency, using CEXs as a benchmark.

Experimental results

Research questions

• RQ1 Do DEXs now offer transaction costs comparable to CEXs, especially after recent protocol upgrades like Uniswap v3?
• RQ2 To what extent do DEXs achieve price efficiency, as measured by deviations from the triangular no-arbitrage condition, relative to CEXs?
• RQ3 What is the causal impact of Uniswap v3’s Discretionary Price Range (DPR) and Multiple Fee Tiering (MFT) on DEX market quality?
• RQ4 How do gas fees and exchange fees act as frictions that reduce DEX price efficiency, particularly in multi-transaction arbitrage strategies?
• RQ5 Can the AMM-based DEX model eventually rival or surpass LOB-based CEXs in market quality, given technological and structural improvements?

Key findings

• DEXs now operate with transaction costs comparable to CEXs, particularly after the introduction of Uniswap v3, which significantly reduced spreads and improved cost efficiency.
• Despite improvements, DEX prices remain less efficient than CEX prices, with deviations from the no-arbitrage condition persisting due to high gas fees and settlement costs.
• The deployment of Uniswap v3 led to a statistically significant and economically meaningful 48% reduction in DEX price deviations relative to CEXs, indicating improved price efficiency.
• The Discretionary Price Range (DPR) mechanism allows liquidity providers to concentrate capital in specific price ranges, leading to narrower spreads, especially for stablecoin pairs.
• Multiple Fee Tiering (MFT) enables traders to choose from multiple pools with different fee levels, enhancing market efficiency and liquidity depth.
• Gas fees remain the primary friction undermining DEX price efficiency, particularly for complex arbitrage strategies requiring multiple on-chain transactions.