Blockchain scaling and liquidity on decentralized exchanges

Abstract

Executing on decentralized exchanges (DEXs) provides a higher level of security for clients’ funds. Clients can execute their trades directly from their own wallet, using smart contracts, and keep custody of their assets. This higher level of security comes at the cost of “gas fees”, which users of a blockchain have to pay to validators for verifying transactions. In this paper, we analyze the effect of gas fees and network speed on execution cost and liquidity distribution on the largest DEX, Uniswap v3. Specifically, we use the entry of Polygon, a scaling solution to the incumbent Ethereum, as an exogenous shock to gas fees reduction and speed increase. We expect that lower gas fees and higher speed on Polygon should lead to higher concentration of liquidity around the market price. Indeed, it becomes easier for liquidity providers to revise their positions and re-post liquidity around the market price. Our preliminary findings show that, whereas overall market depth on Polygon is lower compared to Ethereum, liquidity is indeed more concentrated around the market price. This higher liquidity concentration is especially important for execution of smaller trades. Indeed, we find that price impact for smaller trades (up to $10K) is lower on Polygon, compared to Ethereum.