Darren Kleine

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.&nbsp;



On the Bell Curve podcast (<a href="https://open.spotify.com/episode/2SdHXZx1wutssWaZ7U8AU1?si=uClsl3v-R-GuVR8HScUYbQ">Spotify</a>/<a href="https://podcasts.apple.com/us/podcast/the-lp-profitability-problem-lvr-dynamic-fees/id1641356619?i=1000630026811">Apple</a>), 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 (<a href="https://blockworks.co/price/eth">ETH</a>), 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.&nbsp;



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 <a href="https://blockworks.co/tag/liquidity-provider">liquidity providers</a> (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 <a href="https://blockworks.co/news/the-future-of-web3-needs-zero-gas-fees">transaction cost that is imposed</a> 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.”&nbsp;



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&#8217;s a wide range of outcomes where you make money in some, you lose money in some others, but on average, that&#8217;s a fair game.”



But LVR can tilt the playing field. “The AMM ends up buying <a href="https://blockworks.co/news/bis-cbdc-project-mariana-concludes">at a price that is a little too high</a> [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.”



<h2 class="wp-block-heading">We’re not living in that world</h2>



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.&nbsp;



“However, we&#8217;re not living in that world. We&#8217;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 <a href="https://blockworks.co/news/paradigm-dex-liquidity-value-leaks">aren’t even aware of it</a>. “If you&#8217;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 <a href="https://blockworks.co/podcast/bellcurve/cec1a152-6166-11ee-aa30-43367ff5cbb9">requires further research</a>, Milionis says. As of now, most price discovery is happening on centralized exchanges, he explains, but the problem is tougher to decipher in DeFi.



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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&#8217;s a very interesting research direction,” Milionis reflects, “but I don&#8217;t think we&#8217;ve certainly crystallized to this point as to what&#8217;s the right way to think about price discovery <a href="https://blockworks.co/news/chainlink-functions-developers-oracle-data">on-chain</a>.”



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

Katherine Ross

The Bank of International Settlements announced the conclusion of Project Mariana, which tested cross-border trading and settlement of a central bank digital currency (CBDC).



The project, which spanned months, took place in partnership with the central banks of France, Singapore and Switzerland. The goal was to create a settlement system for a wholesale <a href="https://blockworks.co/tag/cbdc">CBDC</a>, the type of CBDC used between financial institutions. 



The experiment does not necessarily imply that any of the participating countries will adopt a CBDC.&nbsp;



“In the tested experimental setup, central banks are able to manage their wCBDC without necessarily operating or controlling the underlying infrastructure. Commercial banks can use the wCBDCs to engage in instant FX trading and settlement, avoiding credit and settlement risk and improving efficiency,” the paper said.



Throughout the experiment, Project Mariana focused on three elements: “a common technical token standard” which allowed for interoperability between various currencies and was provided by a public blockchain, bridges for the transfers of the CBDCs, and an <a href="https://blockworks.co/tag/amms">automatic market maker</a> (AMM). 



An AMM is a type of decentralized exchange that has “smart contracts that allow traders to exchange one crypto asset — or tokenized assets more generally — for another, by drawing on a common pool of liquidity. Prices are determined by a pre-specified algorithm.”



Project Mariana also discovered some challenges for banks: “For example, the 24 hours a day 7 days a week availability of wCBDC may increase operational complexities for central bank.”&nbsp;



However, it further notes, “commercial banks can use the wCBDCs to engage in instant [foreign exchange] trading and settlement, avoiding credit and settlement risk and improving efficiency.”



Read more: <a href="https://blockworks.co/news/cbdcs-tokenized-deposits-unified-ledger">Combine CBDCs, tokenized deposits on a unified ledger, BIS says</a>



Additionally, “further work is needed to understand the role of central banks and wCBDCs in a broader tokenised ecosystem potentially including stablecoins, tokenised deposits and financial instruments, such as tokenised bonds and securities.”



“Project Mariana pioneers the use of novel technology for interbank foreign exchange markets. It successfully demonstrated that it is feasible to exchange wholesale CBDC across borders using novel concepts such as automated market makers,” said Cecilia Skingsley, head of the BIS Innovation Hub



But the paper also echoes a point made by the BIS chief in a speech earlier this week, “collaboration among stakeholders will be key.”



Agustin Carstens, the general manager of the BIS, said “<a href="https://blockworks.co/news/bis-cbdc-legal-framework-monetary-system">international coordination and cooperation is critical</a>” and that it would be “unfortunate” to have digital currencies that don’t interoperate.



The BIS has been actively researching CBDCs throughout this year, with multiple studies finding that <a href="https://blockworks.co/news/banks-exploring-potential-cbdc">roughly 90%</a> of central banks are interested in exploring “some form” of CBDCs, as well as how <a href="https://blockworks.co/news/bis-cbdc-framework">central banks could properly protect “resilient” CBDC systems</a>.



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Wholesale CBDCs and automatic market makers could be the perfect pair, BIS finds

<div id="highlights-block_632b6d5da851d" class="highlights">
 <ul>
 <li>Liquidity is the lifeblood of crypto — the vast majority of liquidity in crypto is not being used, because it is siloed</li>
 <li>The next generation of AMM will do for DeFi liquidity what Google Fiber did for internet speeds</li>
 </ul>
 
</div>



Decentralized finance promises to allow anyone to have complete control over how they use their money.



But, sadly, the industry is rife with legacy business models from traditional finance that have tainted the waters of DeFi and prevented the industry from reaching its potential.



For crypto projects and their users to get the full benefit of DeFi, we need to fix the very way money is accessed and moved on the blockchain. Just like you expect to be able to simply deposit, withdraw and transfer money from a bank account, you need to be able to easily transfer, swap, sell and buy tokens.&nbsp;



In other words: You need liquidity. 



Liquidity is the lifeblood of crypto. The vast majority of liquidity in crypto is not being used, because it is siloed.&nbsp;



A significant portion of crypto either sits dormant in the wallets of individual users — the DeFi equivalent of keeping cash under your mattress — or on centralized exchanges.



The rest lives across thousands of decentralized protocols, yield farms and pools that can’t readily be accessed by anyone other than their users.



A lack of accessible and easy-to-use liquidity is throttling the growth of DeFi — holding back the crypto projects that are building the future of the internet of value that is Web3.&nbsp;



In the early days of the internet, the industry faced a similar issue. It was expensive and difficult to move information and as a result, Local Area Networks (LANs) were used by large organizations to effectively move data and information around. But that data was stuck. It was siloed within each network, because it was too pricey to move.



Just as increased bandwidth was available for the internet of information to create useful applications for everyday people, improved technology is needed in DeFi to create the internet of value.



So, how do we align incentives between crypto projects and their users and thus encourage people to “put their money to work” in simple and inexpensive liquidity protocols?&nbsp;



How do we make liquidity in DeFi as seamless, efficient and simple to use as the modern internet?&nbsp;



The answer, just as was the case in Web1, is to make it cheaper and easier to use! That will unlock the creativity of crypto and enable the creation of DeFi native applications for buying coffee, getting a home loan, sending money to family in another country or any number of other real life ways people use their money everyday.



Automated market makers (AMM) are the technology that have so far come the closest to making this vision a reality because they make it easy for crypto users to both deposit money into liquidity pools — and get paid rewards for doing so — and pay to access that liquidity. But even the best AMMs remain too expensive or too complicated. Or both. 



The next generation of AMM will do for DeFi liquidity what Google Fiber did for internet speeds — take what was already a quality product (in the case of the internet, broadband) and expand and improve on it massively. 



The next AMM, which hasn’t yet been invented, will further reduce slippage, increase ease for users, and make the entire experience cheaper by finding unique ways to encourage more liquidity to be provided.



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The Future of Automated Market Makers Is Key to Unlocking DeFi Liquidity

Garrett Harper

Vance Spencer and Michael Anderson, co-founders of Framework Ventures, join Jason on today’s episode of “<a href="https://www.youtube.com/watch?v=1KFuND2TIps&amp;ab_channel=BlockworksCrypto" target="_blank" rel="noreferrer noopener">Empire</a>.” The founders have grown Framework’s assets under management from $14 million to over $1.4 billion in just three years.



The co-founders share their thoughts on the layer-2 scaling thesis and why every project will eventually fork their own layer-2. Vance and Michael believe the shift to layer-2s is inevitable — it’s the endgame in maximizing token value.



They then dive into staking and staking derivatives and why the Ethereum merge will bring about the birth of a new industry. This might be the most alpha ever dropped in one podcast — don’t miss it!



Plus, hear more on:



<ul><li>leveraged bets on ETH</li><li>the demise of AMMs</li><li>enterprise blockchains</li><li>ETH 2.0 merge</li><li>And so much more!</li></ul>



Check out what they had to say in the video below.👇



<figure class="wp-block-embed is-type-video is-provider-youtube wp-block-embed-youtube wp-embed-aspect-16-9 wp-has-aspect-ratio"><div class="wp-block-embed__wrapper">
<iframe loading="lazy" title="Every Project Will Have Its Own L2 | Michael Anderson &amp; Vance Spencer" width="1024" height="576" src="https://www.youtube.com/embed/1KFuND2TIps?feature=oembed" frameborder="0" allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture" allowfullscreen></iframe>
</div></figure>



<h3 class="wp-block-heading">About the show</h3>



&#8220;Empire&#8221; is a twice-a-week show where we share the real crypto stories that aren’t heard elsewhere. On Mondays, Jason and Santiago Santos interview crypto industry movers and shakers to talk about their struggles, bold moves and tough decisions. Finish off the week with Friday&#8217;s weekly roundup episode that covers the top news and narratives of the week.



For any NPR or Guy Raz fans out there, you can think of &#8220;Empire&#8221; as a &#8220;How I Built This&#8221; for the bitcoin and crypto industry.



Subscribe to &#8220;Empire&#8221; today on&nbsp;<a href="https://podcasts.apple.com/us/podcast/empire/id1554930038" target="_blank" rel="noreferrer noopener">Apple</a>&nbsp;or&nbsp;<a href="https://open.spotify.com/show/4UTePv1CR3APdKOiosR3Iq" target="_blank" rel="noreferrer noopener">Spotify</a>. Watch episodes on&nbsp;<a href="https://www.youtube.com/channel/UCEOv-8wHvYC6mzsY2Gm5WcQ" target="_blank" rel="noreferrer noopener">YouTube</a>.



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Start your day with top crypto insights from David Canellis and Katherine Ross. <a href="https://blockworks.co/newsletter/empire">Subscribe to the Empire newsletter</a>.