In the automated world of decentralized finance, the term LVR – often pronounced like the word “leverage” – represents the problem of loss versus rebalancing. Jason Milionis describes it simply as “the price of knowledge.”
Any time the price of an asset changes on an external market, the phenomenon can occur, explains the doctoral assistant researcher and recent crypto research intern at Jump Trading Group.
On the Bell Curve podcast (Spotify/Apple), Milionis details some of the intricacies of LVR in DeFi. An automated market maker, or AMM, does not instantly “know” the market price of ether (ETH), for example when the asset is traded on another exchange, such as Coinbase. So AMM tends to lag behind other trading mechanisms, offering “liquidity at outdated prices,” he says.
Savvy traders who are aware of the gap can take advantage of the situation and arbitrage with AMM at “worse than market” prices, says Milionis. This causes MMA liquidity providers (LP) of losing value “exactly because of the informational disadvantage” resulting from the gap between markets.
This scenario of asymmetric information is called “adverse selection.” Alexander Nezlobin, professor of accounting at the London School of Economics, describes LVR as “yet another imposed transaction cost on LPs.
“If you are a passive LP and you want to make money by trading,” he explains, “then you can contribute certain amounts to the protocol of one token (and) another token” .
Price action can work for or against the liquidity provider, Nezlobin explains, depending on its severity. Ideally, if the price fluctuates within a relatively small range, “that’s ideal for vinyl records,” he says. “The LP will make money.”
If the price follows a “random walk,” Nezlobin says, “then there is a wide range of outcomes in which you make money in some, you lose money in others, but on average it is fair game. »
But LVR can tip the scales. “The AMM ends up buying at a price a little too high (and) ends up selling at a price that’s a little too low. And over time, that small transaction cost adds up. And that makes the game unfair for LPs.
We don’t live in this world
In an ideal trading world, without the ability to arbitrage between exchanges and AMMs – and without “alpha” to unduly influence the market – LVR would not exist, said Michael Ippolito, co-founder of Blockworks.
“However, we don’t live in that world. We live in a world where price is discovered on one site and then adjusts to other sites and this gap in timing and knowledge generally leads to the concept of LVR.
What’s really sneaky about the problem, says Ippolito, is that many liquidity providers participating in DeFi I’m not even aware of it. “If you’re not a particularly sophisticated LP, you might make money, but you might lose money waiting for LVR.”
It is a complex problem which requires further research, said Milionis. For now, most price discovery is happening on centralized exchanges, he explains, but the problem is harder to decipher in DeFi.
If an AMM constitutes the dominant part of the order flow, then it becomes more difficult to distinguish how much value is lost due to adverse selection, he says, “which is essentially what LVR represents.”
“It’s a very interesting research direction,” Milionis muses, “but I don’t think we’re clear yet on the right way to think about price discovery. in chain.”
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