Inefficiency of CFMs: hedging perspective and agent-based simulations

Abstract

We investigate whether the fee income from trades on the CFM is sufficient for the liquidity providers to hedge away the exposure to market risk. We first analyse this problem through the lens of continuous-time financial mathematics and derive an upper bound for not-arbitrage fee income that would make CFM efficient and liquidity provision fair. We then evaluate our findings by performing multi-agent simulations by varying CFM fees, market volatility, and rate of arrival of liquidity takers. We observe that, on average, fee income generated from liquidity provision is insufficient to compensate for market risk.

Predictable Losses of Liquidity Provision in Constant Function Markets and Concentrated Liquidity Markets

“…Another strand of the literature explores fee structures for fair compensation of LPs. Evans, Angeris, and Chitra (2021) study optimal fees in geometric markets, Sabate-Vidales and Šiška (2022) study variable fees in CPMs, and Cohen et al (2023) derive a lower bound for fee revenue to make liquidity provision profitable in CFMs. Further, Cartea, Drissi and Monga (2022a), Cartea, Drissi, and Monga (2023), and Jaimungal et al (2023 show how to optimally trade a large position and execute statistical arbitrages using signals in CPMs, Berg et al (2022) empirically study inefficiencies in CFMs, and Bichuch and Feinstein (2022) introduce an axiomatic framework for CFMs and exchange rates.…”