Equilibrium Liquidity and Risk Offsetting in Decentralised Markets

2025-12-22

AI Summary

This paper examines how risk aversion, information asymmetry, and transaction costs jointly influence liquidity providers’ (LPs’) reserve supply decisions in decentralized exchanges (DEXs) and their implications for market depth and trading volume. We develop the first rational-expectations equilibrium model integrating LPs’ risk preferences, cross-market hedging frictions, and asymmetric information, employing game-theoretic modeling, comparative statics, and hedging optimization theory. Our analysis reveals a nonlinear suppression mechanism: rising LP risk aversion significantly reduces reserve supply; unobserved demand enhances market depth, whereas heightened underlying asset volatility and large expected price shifts both trigger liquidity contraction. The key contribution lies in the first unified characterization of LPs’ dynamic, cross-market behavior under multidimensional frictions—providing foundational theoretical insights for DEX liquidity design, protocol engineering, and regulatory policy.

Technology Category

• Game Theory and Economic Paradigms: Mechanism Design
• Multiagent Systems: Mechanism Design
• Search and Optimization: Non-convex Optimization

Application Category

• Economics, Online Markets and Human Computation: Uses of LLMs and GenAI for marketplace design, bidding, and strategic interactions
• Security and Privacy: Cryptocurrency and smart contracts
• Responsible Web: Human-perceived consequences of algorithmic deployment on the web

Abstract

We develop an economic model of decentralised exchanges (DEXs) in which risk-averse liquidity providers (LPs) manage risk in a centralised exchange (CEX) based on preferences, information, and trading costs. Rational, risk-averse LPs anticipate the frictions associated with replication and manage risk primarily by reducing the reserves supplied to the DEX. Greater aversion reduces the equilibrium viability of liquidity provision, resulting in thinner markets and lower trading volumes. Greater uninformed demand supports deeper liquidity, whereas higher fundamental price volatility erodes it. Finally, while moderate anticipated price changes can improve LP performance, larger changes require more intensive trading in the CEX, generate higher replication costs, and induce LPs to reduce liquidity supply.

Problem

• Modeling risk-averse liquidity providers in decentralized exchanges
• Analyzing how risk aversion reduces equilibrium liquidity provision
• Examining effects of price volatility and uninformed demand on liquidity

Innovation

• Risk-averse LPs reduce DEX reserves to manage risk
• Uninformed demand supports deeper liquidity in DEX markets
• Large price changes increase CEX trading and replication costs