Blockchain scaling and liquidity concentration on decentralized exchanges

Paper: arXiv 2306.17742

Abstract

Liquidity providers (LPs) on decentralized exchanges (DEXs) can protect themselves from adverse selection risk by updating their positions more frequently. However, repositioning is costly, because LPs have to pay gas fees for each update. We analyze the causal relation between repositioning and liquidity concentration around the market price, using the entry of blockchain scaling solutions, Arbitrum and Polygon, as our instruments. Lower gas fees on scaling solutions allow LPs to update more frequently than on Ethereum. Our results demonstrate that higher repositioning intensity and precision lead to greater liquidity concentration, which benefits small trades by reducing their slippage.

Complexity vs Empirical Score

• Math Complexity: 4.0/10
• Empirical Rigor: 7.5/10
• Quadrant: Street Traders — practical and empirical, lighter on theory

Why this score: The paper employs econometric methods (instrumental variables) and causal analysis but relies on regression-based empirical evidence without heavy mathematical derivations, focusing on implementation and backtesting-ready data from blockchain scaling solutions.

Research Flowchart

  flowchart TD
  Start["Research Goal: Does cheaper, faster repositioning on scaling solutions increase LP liquidity concentration and reduce slippage for small trades?"]
  Method["Instrumental Variables (IV) Methodology<br>Using Arbitrum & Polygon entry as natural experiments"]
  Inputs["Data: DEX LP Positions & Gas Fees<br>Ethereum (High Cost) vs. Scaling Solutions (Low Cost)"]
  Comp["Computational Process<br>IV Regression Analysis of Repositioning Intensity/Precision"]
  Outcome["Key Findings: Higher repositioning frequency<br>leads to greater liquidity concentration<br>and lower slippage for small trades"]
  Start --> Method
  Method --> Inputs
  Inputs --> Comp
  Comp --> Outcome