Liquidity Misallocation on Decentralized Exchanges

I show that capital is misallocated across liquidity pools on blockchain-based decentralized exchanges. Many pools have persistent abnormal returns, both with respect to factor models and compared to options-implied liquidity premia. Pools with higher past returns continue to have significantly higher risk-adjusted future returns. I show that this return predictability arises because liquidity flow is insensitive to net returns. Instead, liquidity providers chase fee revenues -- the part of return that is prominently marketed as APY -- but ignore adverse selection losses -- the part of return that is implicit and rarely displayed. As a result, pools with higher fee revenues attract more liquidity, even though they tend to have higher adverse selection losses driven by information or sentiment and insignificant returns on net. Aggregate liquidity on decentralized exchanges would have shrunk by one third if liquidity providers were equally sensitive to adverse selection losses