Loss Versus Rebalancing (LVR)

To understand the problems & challenges that CoW is trying to solve we need to look at LVR

Background

There exists a dichotomy where those who want to hold assets cannot market make, and those who can market make need to be paid to hold assets. One of the inefficiencies in the traditional financial sector thus, is the strict separation between retail investors and professional market makers. Retail investors, who want to hold assets like stocks, typically have to pay fund managers to manage these assets for them. Most fund managers employ passive investment strategies, such as simple ETFs, where investors' wealth is distributed across various stocks according to predetermined weights. Consequently, the vast majority of people hold stocks through these types of ETFs. On the other hand, professional market makers, who provide liquidity to the market, view holding assets as Inventory Risk. While they must hold assets to facilitate market making, they prefer not to and require compensation for this service.

In the early days of decentralized finance (DeFi) and automated market makers (AMMs), a promising idea emerged: merging retail investors and professional market makers into a single entity, the Liquidity Provider. This concept proposed that individuals who want to hold assets to gain exposure to certain tokens could also earn additional benefits by putting these assets to productive use in an AMM. This was the initial theory and promise of DeFi and AMMs, aiming to streamline the roles of asset holders and market makers.

Unfortunately, we have reverted to a similar problem found in traditional finance, where market making and providing liquidity (LP) are primarily activities for professionals. These individuals dedicate significant time to studying market conditions, determining optimal price ranges for their liquidity, and adjusting their positions according to specific rules. This complexity makes market making unsuitable for passive liquidity providers, such as retail investors, who prefer not to actively manage their assets. Consequently, retail investors are often better off either holding their tokens in a passive manner elsewhere or participating in lending protocols.

Why did we get to this point?

1. LPing on an AMM is very expensive (Loss vs Rebalancing): Providing liquidity on automated market makers (AMMs) is expensive. Liquidity providers (LPs) are exploited by arbitrageurs during rebalancing events, a phenomenon known in the literature as "loss versus rebalancing" (LVR). Essentially, LPs incur significant costs when putting down liquidity due to arbitrage activities.

2. Swapping on an AMM is very expensive (sandwich attacks): It is costly for traders on AMMs because of "sandwich attacks," where attackers manipulate the order of transactions to exploit traders. This not only affects traders but also complicates the earning of trading fees for LPs.

3. LP's compete with each other to earn trading fees: There is intense competition among LPs for trading fees generated on AMMs. When one LP sees another earning significant fees, they may place their liquidity in the same pool, thereby diluting the original LP’s earnings. This competition extends to placing liquidity within specific price ranges, where profitable ranges attract more liquidity, reducing the fees for all LPs involved. The latest iteration of this competition is called "Just-in-Time" liquidity, where an LP places liquidity right before a large trade to capture the fees, then withdraws immediately, disadvantaging LPs who have committed their liquidity long-term.

The consequence of these issues is paradoxical. Liquidity for blockchain-native assets is deeper in centralized exchanges than in decentralized ones. DeFi has not fulfilled its initial promise of moving the entire financial ecosystem on-chain. Instead, blockchain-native assets are primarily traded off-chain, indicating that we are far from achieving the decentralized financial landscape envisioned at the outset.