In traditional finance (TradFi), market makers and high-frequency traders act as intermediaries on exchanges. Decentralized finance (DeFi) was supposed to offer an alternative, with retail investors crowdsourcing liquidity. The Bank for International Settlements (BIS) was curious about the extent of disintermediation and so analyzed data on decentralized exchange (DEX) transactions. It was found that sophisticated players dominate and are equivalent to professional TradFi intermediaries.
That said, a sophisticated player in the crypto world could still be a spotty teenager working in his parents’ basement, even if he’s rich. From this point of view, DeFi is therefore democratized.
Although retail investors make up 93% of DEX liquidity providers (LPs), a few larger players provide 65-85% of the liquidity on DEXs. They also dominate profits, making an average net return of 3 basis points more per day. This equates to 11.65% more per year compared to retail LPs. While the average retail investor position is $29,000, for professionals the figure is $3.7 million.
The BIS found that retail investors earn about 10% to 25% of commissions and are generally less qualified.
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 linear formula. This meant that a crypto holder could provide liquidity relatively passively.
This changed with Uniswap V3, which encourages liquidity providers to target price ranges that are narrow and close to the market price, helping to provide deeper liquidity around price action. Since prices are dynamic, this requires increased monitoring. If an LP offers a wide range of prices, which retail LPs are more likely to do, their position will sometimes be inactive, earning fewer fees. Research has shown that sophisticated LPs offer significantly narrower tick range spreads, less than half the range of retail LPs.
The introduction of V3 accelerated the transition to sophisticated players. At launch, sophisticated LPs represented 40-50% of transactions, rising to 70-80% by the end of 2023.
Sophisticated LPs feature distinct patterns. They target high volume pools where the daily trading volume exceeds $10 million and completely dominate these pools. Retail LPs provide liquidity to pools with volumes less than $100,000 per day. Sophisticated LPs also target less volatile trading pairs, which carry less risk.
However, when markets go through a period of temporary volatility, the benefits really stand out. At this time, rather than earning 3 basis points more than retail on a daily basis, the figure is 2.5 times higher, at 7.6 basis points.
