| 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. |