Liquidity provision strategies in decentralized market making
Blockchain technology and decentralized finance (DeFi) are driving a new era in the global financial landscape. As of April 2023, the combined market capitalization of all cryptocurrencies amounts to about 1.2 trillion US dollars, demonstrating exponential growth since 2017.
Nico Born, 2023
Bachelor Thesis, Institute for Information Systems, HSW FHNW
Betreuende Dozierende: Hermann Grieder
Keywords: Liquidity Provision strategies in decentralized market making
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Decentralized exchanges, also known as Automated Market Makers (AMMs), are recording monthly trading volumes exceeding 100 billion US dollars, strengthening the rise of an innovative financial ecosystem free from traditional intermediaries.
In the DeFi landscape, AMMs and liquidity providers have replaced traditional market makers. By supplying digital assets to pools on AMMs such as Uniswap, they enable trading for anyone with a smart contract-compatible wallet, simultaneously earning trading fees. However, AMMs are presenting a complex challenge: providing liquidity in a profitable manner.
According to a study conducted by Bancor, over 50% of liquidity providers are underperforming a simple buy-and-hold strategy. This reveals a research gap: the need for studies that present various liquidity provision strategies, demonstrate their practical implementation, and compare their profitability. This paper encompasses a literature review aimed at identifying and outlining prevalent liquidity provision strategies. Utilizing a case study, it further investigates the practical implementation and profitability of these diverse strategies.
Upon comparing the strategies with both volatile assets such as Bitcoin and Ethereum, as well as stablecoins like USDC and USDT, it was observed that
Uniswap V3's concentrated liquidity approach is able to increase profitability considerably. It became clear that each strategy has its own advantages and disadvantages regarding profitability, risk, and implementation difficulties. Uniswap V3 carries various risks that investors must understand before providing concentrated liquidity. From the insights gathered, recommendations were formulated, which also address the issue of impermanent loss and suggest ways to mitigate it.
Equipped with the insights of this paper, liquidity providers can critically evaluate strategies based on the potential risks and rewards, align them with their individual risk tolerance and investment goals, and thus identify and adopt the strategy that best suits their needs. Future research can build upon this paper by exploring the potential for higher APRs through modified liquidity strategies on Uniswap, investigating alternative token pairs and the impacts of external variables on them.
Studiengang: Business Information Technology (Bachelor)
Fachbereich der Arbeit: