Loss Versus Rebalancing (LVR) Explained
Loss Versus Rebalancing (LVR) is a form of Maximal Extractable Value (MEV) that arises from the adverse selection inherent in market making on Automated Market Makers (AMMs)
1. It essentially measures the value that liquidity providers (LPs) lose to arbitrageurs who exploit discrepancies between onchain and offchain cryptocurrency prices
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Key Concepts of LVR
- Cause: LVR occurs because onchain prices update periodically, while cryptocurrency prices fluctuate continuously on offchain venues, such as centralized exchanges 1. This difference creates arbitrage opportunities, particularly for short-tail tokens where price discovery often happens offchain 1.
- Mechanism: Arbitrageurs exploit these price differences, forcing LPs to transact at outdated prices 1. These arbitrage opportunities are typically captured at the top of a block 1.
- Impact on LPs: For liquidity providers, LVR does not result in a realized loss but rather represents an opportunity cost 1. Providing liquidity on an AMM is comparable to running a rebalancing strategy within a price range 1. The LVR is the opportunity cost incurred compared to running a similar rebalancing strategy on a different trading venue where stale prices would be avoided 1.
For example, if an LP sells ETH at an outdated price of $3,000 when the current price is $3,010, the LVR represents the value lost by selling at the lower, stale price
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LVR Mitigation Strategies
The ideal long-term solution for LVR would involve shifting price discovery back to onchain venues, but this is a significant challenge
1. In the meantime, AMMs can incorporate design features to recapture the value lost through LVR and return it to LPs
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Current LVR mitigation designs include:
- Dynamic Fees: Adjusting trading fees based on market conditions can lead to higher returns for LPs 1. However, this approach typically subjects all traders to the same fee adjustment and does not specifically target the arbitrageurs contributing to LVR 1.
- Auctioning Rebalancing Rights: This involves auctioning the right to arbitrage, which helps align onchain prices with offchain prices and reduces LVR 1. For instance, CoW AMM is partnering with Balancer to allow some Balancer pools to auction off LVR through CoW AMM solvers 1.
Despite these mitigation strategies, AMMs that differentiate themselves through LVR mitigation, such as Ambient and CoW AMM, have not yet gained significant market share compared to Uniswap
1. For example, in a 30-day period, CoW AMM had a cumulative volume of $1.1 million and Ambient had $440 million, which is less than 1% of Uniswap's volume of over $60 billion in the same timeframe
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