2025/12/22 by Fayçal Drissi, Drissi, Fayçal, Xuchen Wu +3 · 1 voice · 1 citation
Decision Sciences · Economics, Econometrics and Finance · #Auction Theory and Applications #Banking stability, regulation, efficiency #Economic theories and models #q-fin.GN #q-fin.MF #q-fin.TR
paper · pdf · doi:10.48550/arxiv.2512.19838
arxiv published 2025/12/22 · arxiv updated 2026/03/03
We study the economic viability of liquidity provision in decentralised exchanges (DEXs) within a structural framework in which market outcomes are endogenous. We formulate strategic interactions as a sequential game: a risk-averse liquidity provider (LP) sets the supply of liquidity in the DEX and a costly dynamic replication strategy in a centralised exchange (CEX), price-sensitive traders determine trading volumes, and arbitrageurs align prices. We establish existence of equilibrium under general trading functions. We show that DEX liquidity depth is a central instrument for risk management, because the LP adjusts liquidity ex ante to manage exposure. In addition to the classical trade-off between liquidity demand and adverse selection, we identify two further determinants of the viability of liquidity provision: the ratio of risk aversion to replication costs and private information. The ratio governs the aggressiveness of replication: greater relative risk aversion reduces risk but also lowers equilibrium liquidity and its mean profitability. Private information has a non-monotonic effect. For moderate price movements, speculative benefits increase liquidity. For large price movements, anticipated adverse selection and replication costs lead to thinner markets.