Journal of Financial Market Infrastructures
ISSN:
2049-5404 (print)
2049-5412 (online)
Editor-in-chief: Manmohan Singh
Do DEXs work? Using Uniswap V2 to explore the effectiveness of decentralized exchanges
Need to know
- Uniswap is a decentralized exchange based on liquidity reserves provided by users.
- Ratio of liquidity reserves (the Uniswap price) is cointegrated with the token price off Uniswap.
- An effective decentralized exchange provides continuous liquidity that improves completeness.
Abstract
This paper investigates the function of a blockchain-based decentralized exchange, specifically the effectiveness of the Ether–Tether liquidity pool on the Uniswap V2. We note that cointegration between the price set by the liquidity pool and its price elsewhere is a necessary condition of effectiveness. The trading price offered by the liquidity pool is determined by the token reserves ratio. We apply autoregressive distributed lag, vector autoregressive and vector error correction model methodologies to 154 days of hourly data for the Ether–Tether trading pair. We find that liquidity providers and arbitrageurs ensure that the ratio of reserves is cointegrated with the trading pair price elsewhere, and therefore that Uniswap can be an effective financial market. This raises the possibility that such decentralized exchanges could be used to improve the completeness of financial markets.
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