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Expected Returns of Liquidity Providers with Automated Market Makers

A Decentralized Exchange (DEX) is the most popular Decentralized Finance (DeFi) protocol. DEXs adopted a unique system called liquidity pools with Automated Market Makers (AMMs), which consists of two types of participants: liquidity providers and traders. The expected returns of liquidity providers are important as it is related to the growth limit of the system. I estimate the expected return of liquidity providers using the realized kernel and compare the expected return of ETH/USDC liquidity pools in Uniswap, the most popular DEX. The liquidity providers for the V2 pool showed a 9.15% expected annual return, whereas the expected annual returns of liquidity providers for the V3 pools were almost zero. This difference presumably relates to trading costs from lower gas fees in V2. I also find that the expected returns in the V2 pool have decreased after the launch of the V3. It implies that greater liquidity benefits traders but undermines the profit of liquidity providers.


Financial econometrics, Cryptocurrency, Blockchain, Decentralized Finance, Market Microstructure

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