The Alpha of AMM Design is LVR
Introduction: Setting the Stage for LVR
Maximal extractable value (MEV) is the alpha that is extracted from users by sophisticated actors who have the capacity and resources to convert information asymmetries into profitable trading strategies. Although the concept is crypto-native, it also exists in TradFi and even non-financial information technologies.
In DeFi there exists the precedent to redesign financial markets in such a way that infrastructure and applications become MEV-aware. Such systems would effectively create a competition that repurposes sophisticated actors to redirect alpha back to users, rather than extract all of it.
As it pertains to AMMs, it is important to understand the tradeoffs for liquidity providers (LPs) in order to build solutions that service them. Moreover, the MEV that LPs lose can be defined as Loss-vs-Rebalancing (LVR, “lev-er”). Therefore, the alpha of AMM design is LVR–the best AMMs will have the lowest LVR because they recapture that alpha for LPs. Put differently, Citadel's Sharpe is Uniswap's Opportunity. In a low LVR future, onchain economies are more liquid, sustainable, and profitable.
What is Loss-vs-Rebalancing?
On Ethereum, every 12 seconds, onchain prices adjust to offchain prices. If the price of an asset on a DEX does not equal the price of that asset on a CEX, there is a CEX-DEX arbitrage opportunity in which a market-maker (MM) on the CEX trades against LPs on a DEX. In such a case, the MM takes a profit and the LP loses–LVR is thus a measurement of LP losses.
LVR is precisely the adverse-selection cost that LPs on AMMs incur from toxic flow (i.e. order flow originating from high-signal sharpe traders who possess an asymmetrical information edge), primarily via CEX-DEX arbitrage. Coined in this research by Milionis et al, the usage of LVR to evaluate LP performance has since driven the discourse for AMM R&D.
