Uniswap V3 Liquidity Pools Are Still Dominated By a Few Large Participants – BIS Study

A November 2024 study by the Bank for International Settlements (BIS) has cast doubt on the decentralized nature of decentralized finance (DeFi).

By analyzing the Ethereum blockchain, researchers delved into the inner workings of Uniswap V3, one of the largest decentralized exchanges (DEXs).

The study focused on the top 250 liquidity pools (LPs), which collectively account for approximately 96% of the total trading volume on Uniswap v3. By reconstructing the state of these pools at the transaction level, researchers – Matteo Aquilina, Sean Foley, Leonardo Gambacorta and William Krekel – were able to gain insights into the behavior of both retail and institutional liquidity providers.

Uniswap V3 Liquidity: A Centralized Reality?

The study found that a select few “sophisticated agents” control a significant portion of the liquidity pools. “These players hold about 80% of total value locked and focus their attention on liquidity pools that have the most trading volume and are less volatile,” the analysts said in the report. These players, often employing advanced trading strategies and leveraging significant capital, outcompete retail investors.

#DeFi liquidity on decentralised exchanges like #Uniswap is dominated by a small, skilled group of sophisticated players, earning higher returns than retail participants. Is decentralisation just a myth? #Crypto https://t.co/AaRFwwsD5b pic.twitter.com/nPHBBcQzRJ

— Bank for International Settlements (@BIS_org) November 19, 2024

As a result, retail participants, who often lack the resources and expertise of these sophisticated players, are left with a significantly smaller share of trading fees and lower returns on their investments. In fact, the study found that in many cases, retail investors lose money on a risk-adjusted basis:

“While the average return for retail LPs is positive, this is driven by the high profitability of a select few. In more than half of the days in our sample, retail LPs lose money on a risk-adjusted basis.”

DeFi’s Centralization Tendencies

The BIS study suggests that inherent economic forces, similar to those in traditional finance, drive centralization, even in the decentralized world of DeFi. According to the researchers, this revelation calls into question the core principle of DeFi, which is to democratize finance and “provide equal opportunities for all participants”:

“Our findings highlight a trend where the ability to provide liquidity is becoming consolidated in the hands of a few sophisticated participants, with retail participants unable to effectively compete with them. Simply allowing all participants access to a protocol does not appear to eliminate such forces and has not – to date – resulted in a truly disintermediated market.”

BIS Study May Overstate Degree of Centralization – Expert

However, Gordon Liao, Chief Economist and Head of Research at Circle and prior Head of Research at Uniswap Labs, offered a contrasting perspective in his X post from Nov. 19.

Liao argued that the BIS study may overstate the extent of centralization. The expert highlights that the “sophisticated” traders identified in the study, while responsible for a larger share of total value locked (TVL) and earning a higher proportion of fees, only see a marginal improvement (less than 15%) in fee earnings compared to less-sophisticated users. Liao suggests this doesn’t necessarily indicate a significant advantage.

Liao further argues that the situation for retail investors in traditional, central limit order book (CLOB) markets is far worse, citing a research paper published on ScienceDirect. He points out that tick ranges in CLOB markets are typically much wider than the 1-2% mentioned in the BIS study, and liquidity can be even more concentrated in stablecoin pairs.

While acknowledging some of the BIS study’s findings, such as the limited impact of just-in-time (JIT) liquidity, Liao highlights the importance of default tick range in influencing liquidity provision. He suggests that by optimizing default settings and utilizing vaults, the user experience can be improved and liquidity positions can be optimized.

Interesting paper on AMM liquidity provision. Though I would almost draw the opposite conclusion from the data.

The "sophisticated" traders labeled by the authors are overall responsible for ~70% of TVL and earns 80% of fees, that's a <15% improvement in fee earnings,… https://t.co/YsiR9Lgvx7 pic.twitter.com/HhcNEo5h3N

— Gordon Liao (@gordonliao) November 19, 2024