Equilibrium Liquidity and Risk Offsetting in Decentralised Markets
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arXiv
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| Hauptverfasser: | , , |
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| Format: | Preprint |
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2025
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| author | Drissi, Fayçal Wu, Xuchen Jaimungal, Sebastian |
| author_facet | Drissi, Fayçal Wu, Xuchen Jaimungal, Sebastian |
| contents | 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. |
| format | Preprint |
| id |
arxiv_https___arxiv_org_abs_2512_19838 |
| institution | arXiv |
| publishDate | 2025 |
| record_format | arxiv |
| spellingShingle | Equilibrium Liquidity and Risk Offsetting in Decentralised Markets Drissi, Fayçal Wu, Xuchen Jaimungal, Sebastian Trading and Market Microstructure General Finance Mathematical Finance 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. |
| title | Equilibrium Liquidity and Risk Offsetting in Decentralised Markets |
| topic | Trading and Market Microstructure General Finance Mathematical Finance |
| url | https://arxiv.org/abs/2512.19838 |