Liquidity Shocks, Token Returns and Market Capitalization in Decentralized Finance (DeFi) Markets

Abstract

This paper investigates the market reaction to large positive or negative liquidity shocks on the value of tokens traded on decentralized exchanges (DEXes) on the Ethereum blockchain. Automated market makers (AMMs) and constant product markets provide transparent and decentralized ways to directly swap two blockchain tokens for each other via the use of liquidity pools. Using trade-by-trade data of 2.77 million swaps of 14 different tokens traded on Uniswap v2, v3 and SushiSwap, we find that the size of sell orders significantly correlates with negative future token returns, while buy size positively correlates with future token returns. Using an event study approach, we quantify the market reaction of unusually large sell and buy orders (top 1% percentile) and identify that the market reaction outweighs the economic value of the event by a factor of -7.4 for sell orders and +4.4 for buy orders over a short-span trading window. In the case of sell orders, a high proportion of the abnormal return is already realized before the event, which indicates informed trading in the form of arbitrage or frontrunning via Miner Extractable Value (MEV). Looking at individual crypto assets, we find a mean reassessment of token value following short sales of up to 0.79% within just one follow-up trade (buy orders up to 0.50%). The findings indicate that price shocks may have a signaling effect but also that market capitalization may be an insufficient metric for assessing the liquidity and valuation of (inefficient) crypto assets. The results suggest multiple challenges for investor protection in decentralized finance (DeFi) markets.