In DeFi, automated market makers (AMMs) are where traders and liquidity providers (LPs) meet, but understanding the true cost of providing liquidity is complex. Traditionally, LP costs have been understood in terms of ‘impermanent loss’, which compares AMM returns to a simple ‘buy and hold’ approach. Now, LVR (Loss Versus Rebalancing) provides a more accurate metric that focuses on adverse selection and arbitrage costs by comparing LP outcomes to a rebalancing strategy.
Impermanent loss: the standard measure
To understand why LVR is different, let’s take a quick look at impermanent loss, the traditional measure of LP costs. Impermanent loss occurs when LPs would have been better off holding tokens outside the AMM rather than providing liquidity. It simply compares the value of tokens held by LPs in an AMM to the hypothetical value of the same tokens if they were simply held in a wallet.
Impermanent loss example
Imagine you deposit 1 ETH and 1000 USDC into an ETH-USDC AMM. When you deposit, the ETH price is $1000. Suppose the ETH price later quadruples to $4000.
If you held outside the AMM, your portfolio would be worth $5000: 1 ETH ($4000) plus 1000 USDC. Inside the AMM, however, your holdings would have been rebalanced to approximately 0.5 ETH and 2000 USDC, for a total value of $4000. This $1000 difference represents the impermanent loss, the “cost” of providing liquidity rather than simply holding.
Impermanent loss doesn’t take into account what happens along the way as prices fluctuate, it only considers the starting and ending price points. This is where LVR comes in, providing a more accurate measurement for LPs who want to understand the true cost of providing liquidity, including arbitrage losses.
What is LVR?
LVR quantifies the losses LPs incur due to price fluctuations that create arbitrage opportunities. Rather than simply looking at token price changes over time, LVR compares AMM liquidity provision to a rebalancing approach where trades are mirrored at current market prices. This approach captures the ongoing losses LPs incur when arbitrageurs capitalise on stale AMM prices.
LVR example
Imagine you’re an LP in an ETH-USDC pool, starting with 1 ETH and 1000 USDC. Suddenly the price of ETH jumps from 1000 USDC to 4000 USDC.
An arbitrageur takes advantage of this price difference by buying 0.5 ETH from the AMM at an average price of $2000 per ETH. As an LP, after this adjustment you now hold 0.5 ETH and 2000 USDC, for a total value of $4000.
This is where the LVR comes in: if you had followed a rebalancing strategy, you would have also sold 0.5 ETH at the market price of $4000 (instead of at the lower AMM price), giving you a portfolio worth $5000 (original 1000 USDC + 0.5 ETH + 2000 USDC from the last 0.5 ETH sale). The LVR, or Loss Versus Rebalancing, is this $1000 difference.
Unlike impermanent loss, which only considers the start and end prices, LVR captures the true cost of providing liquidity in an AMM by measuring the losses incurred at each arbitrage opportunity – each time market prices and AMM prices diverge.
Why does LVR matter?
For AMM designers, LVR highlights the need for structures that protect LPs from adverse selection costs. This could mean adaptive fees that scale with volatility, or high quality oracles that price closer to the market, minimising arbitrage windows. LVR insights help LPs make informed decisions, creating healthier AMMs for the DeFi ecosystem.
By understanding LVR, we’re moving towards a more efficient and sustainable model for providing liquidity in DeFi.
