Toxicity-Competitiveness Trade-off in Concentrated Liquidity Provision at a Decentralized Exchange

This paper investigates whether concentrated liquidity in decentralized exchanges protects liquidity providers (LPs) against toxic swaps, relative to traditional AMM liquidity provision mechanisms. To address this question, we develop a model of LP competition and uncover a fundamental toxicity-competitiveness trade-off: toxic swaps yield payoffs independent of other LPs’ strategies, whereas non-toxic swaps generate payoffs that depend on strategic competition among LPs. We demonstrate that concentrated liquidity increasingly outperforms traditional mechanisms as swap toxicity rises, while at low toxicity levels, competitive pressure can instead worsen LP payoffs. Comparative statics further show that equilibrium liquidity provision rises with toxicity, volatility, and LP competition but falls with fees. Together, these patterns suggest how LPs should optimally adjust their strategies to market conditions.