In traditional finance (TradFi), market makers and high frequency traders act as intermediaries on exchanges. Decentralized Finance (DeFi) was meant to provide an alternative, with retail investors providing liquidity in a crowdsourcing manner. The Bank for International Settlements (BIS) was curious about the extent of disintermediation, so it crunched the data on decentralized exchange (DEX) transactions. It found that sophisticated players dominate and are equivalent to professional intermediaries in TradFi.
That said, a sophisticated player in the crypto world could still be a spotty teenager working in their parent’s basement, albeit a wealthy one. So from that perspective, DeFi is democratized.
Despite retail investors making up 93% of DEX liquidity providers (LPs), a few larger actors provide 65-85% of the liquidity on DEXs. They also dominate profits, making an average net return of 3 basis points more daily. That’s equivalent to 11.65% more annually compared to retail LPs. While the average position of a retail investor is $29,000, for the professionals, the figure is $3.7 million.
The BIS found that retail investors earn about 10-25% of fees and are generally less skilled.
More sophisticated AMMs favor the pros
The study focused on Uniswap V3. In the early days of DeFi, the algorithmic model used by most automated market makers (AMMs) was a crude straight line formula. That meant that a crypto holder could provide liquidity in a relatively passive manner.
That changed with Uniswap V3, which encourages liquidity providers to target narrow price ranges close to the market price, helping to provide deeper liquidity around the price action. Given prices are dynamic, that requires more monitoring. If an LP provides a broad price range, something retail LPs are more prone to do, their position will be inactive some of the time, earning less fees. The research showed that sophisticated LPs provided significantly narrower tick range spreads, less than half of retail LPs’ range.
The introduction of V3 has accelerated the shift to sophisticated players. At launch, sophisticated LPs accounted for 40-50% of transactions, rising to 70-80% by the end of 2023.
Sophisticated LPs show distinct patterns. They target high volume pools where daily trading volume exceeds $10m, and they completely dominate those pools. Retail LPs provide liquidity to pools where volumes are less than $100,000 a day. Sophisticated LPs also target less volatile trading pairs, which are lower risk.
However, when the markets are in a temporary volatile period, the pros really stand out. During those times, rather than earning 3 basis points more than retail daily, the figure is 2.5 times higher at 7.6 basis points.
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