The Paradox Of Just-in-Time Liquidity in Decentralized Exchanges: More Providers Can Sometimes Mean Less Liquidity

We study just-in-time (JIT) liquidity provision within blockchain-based decentralized exchanges (DEXs). In contrast to passive liquidity providers (LPs) who deposit assets into liquidity pools before observing order flows, JIT LPs take a more active approach. They monitor pending orders from public blockchain mempools and swiftly supply liquidity, only to withdraw it in the same block. Our game-theoretical analysis uncovers a paradoxical scenario: the presence of a JIT LP, rather than enhancing liquidity as expected, can inadvertently reduce it. A central reason behind the paradox is the adverse selection problem encountered by passive LPs, stemming from the presence of informed arbitrageurs. Unlike passive LPs, JIT LPs have the advantage of analyzing the order flow prior to providing liquidity and block confirmation. We show that this second-mover advantage mitigates their adverse selection costs and potentially crowds out passive LPs, particularly when order flows are not highly elastic to changes in pool liquidity. These equilibrium effects may lead to an overall reduction of pool liquidity and to an increased execution risk for liquidity demanders. To alleviate the detrimental effects of JIT liquidity, we propose a two-tiered fee structure for passive and JIT LPs. We show that this structure may prevent crowding out and improve welfare.