An Economic Model of a Decentralized Exchange with Concentrated Liquidity

Abstract

We develop a model of a decentralized exchange that allows investors to concentrate liquidity within pre-specified price intervals (e.g., Uniswap V3). Providing liquidity for a risky/risk-free asset pair within any interval is analogous to investing in a dynamic portfolio of those assets, subject to an arbitrage cost, where the risky asset weight declines as its price increases. We derive equilibrium liquidity provision for each price interval and provide a simple approximation that can be useful for empirical work. We also show that liquidity provision generates an ex-fee return approximately equivalent to the return from a covered call trading strategy.

Presented by Fahad Salah