amm investments have become increasingly popular in recent years as a way to earn yield in the crypto space. However, being an amm LP comes with risks and costs that need to be weighed carefully. This article summarizes 4 key takeaways on how to think about pricing the costs of providing liquidity in amms based on a new framework called LVR (loss to value ratio) proposed by a16z.
LPs bear impermanent loss from price volatility
When asset prices change in an AMM, LPs suffer impermanent losses as their share of the pool becomes imbalanced compared to just holding the assets. LVR quantifies these losses relative to a simple hold.
LVR accumulates with trade volume and volatility
Instantaneous LVR at any time is proportional to price volatility and trade volume. Over time, LVR accumulates based on the price path, scaling with total volatility.
LVR guides LP profitability thresholds
LPs profit when trading fees exceed LVR. Higher volatility means LVR increases faster, so higher trade volume is needed for profitability.
Dynamic fees or better pricing can minimize LVR
AMMs could adjust fees based on volatility to maintain LP profits. Also, using accurate external pricing via oracles can minimize LVR by avoiding large divergences.
LVR provides a new framework for quantifying the key cost faced by AMM LPs – impermanent loss from providing liquidity when prices change. By modeling how LVR accumulates over time based on volatility and trade volume, it offers insights into LP profitability, incentives, and AMM design.