DeFi Investments: Automated Market Making risks and Loss-Versus-Rebalancing Concept

Decoding DeFi: Is Automated Market Making Setting You Up for Loss?

Samir D’Costa in Business & Economy December 2025 • 3 min read.

"Uncover the hidden risks of providing liquidity to AMMs and how 'loss-versus-rebalancing' could be the key to protecting your investments in decentralized finance."

Decentralized finance (DeFi) has exploded in popularity, offering innovative ways to trade and manage digital assets. At the heart of this revolution are Automated Market Makers (AMMs), protocols that allow users to trade cryptocurrencies without traditional intermediaries. By providing liquidity to these platforms, users can earn fees, creating a seemingly passive income stream.

However, beneath the surface of enticing returns lies a complex reality. Liquidity providers (LPs) often face a subtle but significant challenge: impermanent loss. This occurs when the price of assets within an AMM diverge, leading to a reduction in the value of an LP's holdings compared to simply holding the assets outside the pool. Understanding this dynamic is crucial for anyone participating in DeFi.

New research has shed light on a more precise way to understand these losses, introducing the concept of 'loss-versus-rebalancing' (LVR). This framework offers a clearer picture of the risks involved and provides strategies to potentially minimize them, ensuring a more secure and profitable DeFi experience.

What is 'Loss-Versus-Rebalancing' and Why Does It Matter?

DeFi Investments: Automated Market Making risks and Loss-Versus-Rebalancing Concept

The core idea behind loss-versus-rebalancing is to compare the performance of an AMM liquidity provider to a benchmark strategy: a rebalancing strategy. Imagine an AMM is a portfolio that is rebalancing to maintain constant weights, the rebalancing strategy does at CEX.

Here's where the 'loss' part comes in. AMMs, due to their design, trade at slightly worse prices than those available on centralized exchanges. This difference, known as price slippage, is the primary driver of LVR.

Price Slippage: The difference between the expected price of a trade and the price at which the trade is executed.
Stale Prices: AMM quotes don't automatically update.
Rebalancing Strategy: Is that strategy that is dynamically updating the AMM weights.

This underperformance stems from the fact that AMMs are passive liquidity providers, relying on arbitrageurs to correct price discrepancies. This means LPs are vulnerable to being 'sniped' – having their stale quotes exploited by faster, more informed traders.

Protecting Your DeFi Investments

The world of DeFi is constantly evolving, and understanding the nuances of AMMs is critical for making informed investment decisions. By recognizing the risks associated with LVR and exploring strategies to mitigate them, you can navigate the decentralized landscape with greater confidence.

About this Article -

This article was crafted using a human-AI hybrid and collaborative approach. AI assisted our team with initial drafting, research insights, identifying key questions, and image generation. Our human editors guided topic selection, defined the angle, structured the content, ensured factual accuracy and relevance, refined the tone, and conducted thorough editing to deliver helpful, high-quality information.See our About page for more information.

This article is based on research published under:

DOI-LINK: https://doi.org/10.48550/arXiv.2208.06046,

Title: Automated Market Making And Loss-Versus-Rebalancing

Subject: q-fin.mf math.oc q-fin.pm q-fin.pr q-fin.tr

Authors: Jason Milionis, Ciamac C. Moallemi, Tim Roughgarden, Anthony Lee Zhang

Published: 11-08-2022

Everything You Need To Know

What are Automated Market Makers (AMMs) and how do they function within decentralized finance (DeFi)?

Automated Market Makers (AMMs) are protocols that enable the trading of cryptocurrencies without traditional intermediaries by using liquidity pools. Users provide liquidity to these pools and earn fees in exchange, which creates a seemingly passive income stream. This system relies on algorithms to determine asset prices based on the pool's supply and demand, differing from traditional order book exchanges.

What is 'loss-versus-rebalancing' (LVR) and why is it important for liquidity providers (LPs) in AMMs?

'Loss-versus-rebalancing' (LVR) is a framework used to compare the performance of an AMM liquidity provider to a rebalancing strategy and shows the impact of AMMs passively providing liquidity and relying on arbitrageurs to correct price discrepancies. It helps LPs understand how their returns stack up against a simple rebalancing strategy, highlighting potential losses due to price slippage and stale quotes. Understanding LVR is crucial for assessing the real profitability and risks associated with providing liquidity to AMMs.

What is price slippage in the context of Automated Market Makers (AMMs), and how does it contribute to potential losses for liquidity providers (LPs)?

Price slippage refers to the difference between the expected price of a trade and the actual price at which the trade is executed within an Automated Market Maker (AMM). This discrepancy arises because AMMs don't automatically update quotes and trade at slightly worse prices than centralized exchanges (CEX). Liquidity Providers (LPs) face the risk of being 'sniped' when arbitrageurs exploit these stale quotes, contributing to losses measured by 'loss-versus-rebalancing'.

How does the 'rebalancing strategy' compare to the returns of a typical liquidity provider in an Automated Market Maker (AMM)?

The 'rebalancing strategy' serves as a benchmark to measure the performance of liquidity providers in AMMs. By comparing an AMM's return to the rebalancing strategy, 'loss-versus-rebalancing' quantifies how much LPs lose due to factors like price slippage and stale prices. This comparison is crucial because it reveals the opportunity cost of providing liquidity to an AMM versus simply holding and rebalancing the assets, which can expose hidden costs and potential underperformance.

How can liquidity providers (LPs) protect their Decentralized Finance (DeFi) investments against 'loss-versus-rebalancing' (LVR) in Automated Market Makers (AMMs)?

To protect against 'loss-versus-rebalancing', liquidity providers need to understand and mitigate risks associated with AMMs. Awareness of concepts like price slippage and stale prices is essential. Strategies might include choosing AMMs with lower trading volumes or employing sophisticated trading algorithms to react faster to price changes. Further research into minimizing LVR could involve diversification across different AMMs or assets, or hedging strategies outside the AMM. While the text does not provide specific strategies, the knowledge of LVR provides a foundation to explore mitigation techniques.