Behind the times: how LVR is an ‘unfair game’ for DeFi liquidity providers

In the automated world of decentralized finance, the term LVR — often pronounced as the word “lever” — represents the problem of loss-versus-rebalancing. Jason Milionis describes it simply as “the price of knowledge.”

Whenever the price of an asset changes in an external market, the phenomenon can occur, the PhD student assistant researcher and recent crypto researcher intern at Jump Trading Group explains.

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. Thus, the AMM is prone to falling behind other trading mechanisms, offering “liquidity at stale prices,” he says.

Savvy traders who are aware of the discrepancy can take advantage of the situation and arbitrage with the AMM at “worse than market prices,” Milionis says. This causes the AMM’s liquidity providers (LPs) to lose value “exactly because of the informational disadvantage” that resulted from the lag between markets.

This information asymmetry scenario is termed “adverse selection.” Alexander Nezlobin, professor of Accounting at the London School of Economics describes LVR as “yet another transaction cost that is imposed on LPs.”

“If you are a passive LP and you want to make money by making the market,” he explains, “then you can contribute some amounts to the protocol of one token [and] of another token.”

Price movement can work either for or against the liquidity provider, Nezlobin says, depending on its severity. Ideally, if the price fluctuates in a relatively small range, “it’s great for LPs,” he says. “The LP will be making money.”

If the price follows a “random walk,” Nezlobin says, “then there’s a wide range of outcomes where you make money in some, you lose money in some others, but on average, that’s a fair game.”

But LVR can tilt the playing field. “The AMM ends up buying at a price that is a little too high [and] ends up selling at a price that is a little too low. And over time, this little transaction cost accumulates. And so that makes the game unfair to the LPs.”

We’re not living in that world

In an ideal trading world with no possibility for arbitrage between exchanges and AMMs — and no “alpha” to unduly influence the market — LVR wouldn’t exist, Blockworks co-founder Michael Ippolito says.

“However, we’re not living in that world. We’re living in a world where price is discovered on one venue and then it adjusts to other venues and that discrepancy in terms of timing and knowledge generally leads to the concept of LVR.”

What’s really devious about the problem, Ippolito says, is that a lot of participating liquidity providers in DeFi aren’t even aware of it. “If you’re not a particularly sophisticated LP, LP’ing along, you might be making money, but you might be losing money in expectation from LVR.”

It’s a complex problem that requires further research, Milionis says. As of now, most price discovery is happening on centralized exchanges, he explains, but the problem is tougher to decipher in DeFi.

If an AMM is the dominant part of the order flow, then it becomes more difficult to distinguish the quantity of value lost due to adverse selection, he says, “which is basically what LVR represents.”

“It’s a very interesting research direction,” Milionis reflects, “but I don’t think we’ve certainly crystallized to this point as to what’s the right way to think about price discovery on-chain.”

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