Liquidity Provision on Blockchain-Based Decentralized Exchanges

Abstract

Abstract We show that the infrastructure of decentralized exchanges subjects liquidity providers (LPs) to a “tragedy of the commons.” Liquidity providers lack incentives to exit liquidity pools to prevent arbitrage losses, as these are collectively shared, while withdrawal costs are borne individually. Arbitrage rents primarily flow to validators as infrastructure fees, with the median arbitrageur transferring 96% of profits. Proposed solutions—speed technology, alternative sequencing rules, and flexible pricing curves—fail to reduce these rents. Leveraging the Silicon Valley Bank crisis as a natural experiment, we show that LPs defensively adopt more convex pricing curves to mitigate adverse selection risks.