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

TL;DR

The paper analyzes just-in-time (JIT) liquidity provision in decentralized exchanges, showing that JIT liquidity can either enhance or reduce market liquidity depending on how uninformed order flow responds to pool depth. It develops a game-theoretic model with passive LPs, a JIT LP, informed and uninformed traders, and an AMM with a Uniswap-v3–like pricing function, deriving a threshold $\underline{\zeta}(f,\pi)$ that governs the existence of a non-trivial SPNE. A key finding is that when uninformed demand is highly elastic, JIT and passive LPs are complements and total liquidity rises; when elasticity is low, crowding out can occur and liquidity may freeze. To mitigate negative effects, the paper proposes a two-tier fee structure that reallocates a portion of JIT fees to passive LPs and analyzes Cournot competition between multiple JIT LPs, finding that competition lowers the crowding-out threshold and can improve welfare. The results offer practical guidance for AMM design, suggesting mechanisms to preserve liquidity depth while enabling active JIT participation.

Abstract

We study Just-in-time (JIT) liquidity provision in blockchain-based decentralized exchanges. A JIT liquidity provider (LP) monitors pending swap orders in public mempools of blockchains to sandwich orders of their choice with liquidity, depositing right before and withdrawing right after the order. Our game-theoretic model with asymmetrically informed agents reveals that a JIT LP's presence does not always enhance liquidity pool depth, as one might expect. While passive LPs face adverse selection by informed arbitrageurs, a JIT LP's ability to detect pending orders for toxic order flow prior to liquidity provision lets them avoid being adversely selected. JIT LPs thus only provide liquidity to uninformed orders and crowd out passive LPs when order volume is not sufficiently elastic to pool depth, possibly reducing overall market liquidity. We show that using a two-tiered fee structure which transfers a part of a JIT LP's fee revenue to passive LPs or allowing for JIT LPs to compete à la Cournot are potential solutions to mitigate the negative effects of JIT liquidity.

Figures (4)

• Figure 1: Timeline of the sequential game.
• Figure 2: $\zeta^\star(1)=(\sqrt{f}+\sqrt{1+f})^2$ is a threshold for crowding out and complementing when the JIT arrives with probability one. Here $f=0.03$ (chosen to illustrate the threshold the best), yielding $\zeta^\star(1)\approx1.4116$.
• Figure 3: Passive LPs' per-unit utility and welfare against $\lambda$. We fixed $\pi=1$, $f=0.003$, $\zeta=1.05$, $\psi=\zeta/(\zeta+1)$, $\zeta_U=1.02$, $\psi_U=\zeta_U/(\zeta_U+1)$, and $\alpha=0.1$.
• Figure 4: The threshold $\zeta_U^\star$ between complementing and crowding out under competing JIT LPs and under a monopolist JIT LP given the amount of passive liquidity provided. We fixed $f=0.01$, $\pi=0.5$, $e_J=3$, and $e_P=1$.

Theorems & Definitions (46)

• Proposition 3.1
• Proposition 3.2
• Definition
• Theorem 3.3
• Proposition 4.1
• Proposition 4.2
• Theorem 4.3
• Theorem 4.4
• Proposition 5.1
• Proposition 5.2