Automated Market Making and Loss-Versus-Rebalancing

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Paper Summary

Conflicts of Interest

Identified Weaknesses

Rating Explanation

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Paper Summary

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DeFi's Invisible Tax: How Arbitrageurs Snipe Your Crypto Pool Profits, and How to Hide Your Risk!

This paper develops a Black-Scholes-inspired model to quantify "loss-versus-rebalancing" (LVR), the cost incurred by decentralized exchange liquidity providers due to price slippage from informed arbitrageurs. The model shows that AMM LPs systematically trade at worse-than-market prices, with LVR depending on asset volatility and marginal liquidity. Empirically validated on Uniswap v2 WETH-USDC, the study demonstrates that delta-hedging LP positions significantly reduces market risk, making LP returns primarily a bet on fees offsetting LVR.

Possible Conflicts of Interest

Tim Roughgarden is Head of Research at a16z Crypto, a venture capital firm with significant investments in automated market making protocols. This affiliation presents a potential conflict as his research directly pertains to the profitability and design of systems that a16z Crypto invests in, potentially influencing the firm's strategic decisions or benefiting its portfolio companies. Additionally, Jason Milionis received an unrestricted gift from Gnosis, Ltd., another crypto project, which could also be seen as a minor conflict.

Identified Weaknesses

Idealized Model Assumptions

The core model operates under frictionless, continuous-time Black-Scholes assumptions, including an infinitely deep centralized exchange, no arbitrageur fees, and no blockchain transaction fees (gas fees). This simplifies the analysis but may not fully capture the complexities and costs of real-world decentralized finance (DeFi) environments, potentially underestimating actual LP losses or arbitrage costs.

Limited Empirical Scope

The empirical validation is primarily based on a single trading pair (Uniswap v2 WETH-USDC) over a one-year period. While providing evidence for the model's realism in this specific context, the findings may not generalize perfectly to all AMMs, other asset pairs, or different market conditions without further empirical testing.

Arbitrageur Profit Simplification

The paper states that arbitrageur profits equal LVR, but this relies on the assumption of no fees for arbitrageurs. In practice, arbitrageurs incur transaction costs and gas fees, which would reduce their actual profits and potentially impact the precise balance between LVR and fees needed for AMM redesign.

Rating Explanation

The paper presents a novel and well-developed theoretical model for understanding AMM LP losses (LVR) that is also quantitatively realistic and empirically validated. Its insights into delta-hedging and the distinction from impermanent loss are significant contributions to DeFi research. The limitations regarding idealized model assumptions and empirical scope are acknowledged by the authors and are common in foundational theoretical work. The conflicts of interest are noted but do not fundamentally undermine the scientific rigor of the methodology itself.

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