Dynamic AMM Fees to Protect Liquidity Provider Returns

Summary

This study examines how automated market maker fees affect passive liquidity provider profitability when the AMM competes with a centralized exchange. In its reduced-form model, traders route orders toward the better price while arbitrageurs trade against price discrepancies. These mechanisms expose liquidity providers to adverse selection losses, which static fees may not offset.

Using large-scale simulations and calibration with real market data, the analysis relates LP profits and optimal fees to conditions such as volatility and trading volume. Fees face a trade-off: they need to attract order flow while also generating revenue and covering arbitrage losses. Under ordinary conditions, the optimal fee is described as competitive with centralized exchange trading costs and relatively stable; in very high volatility, a higher fee can protect providers from larger losses. The proposed threshold-style dynamic schedule is a model-based result, and its usefulness depends on how well the model and calibration represent actual market behavior.

Key ideas

• The model includes competition between an AMM and a centralized exchange, with traders routing orders and arbitrageurs exploiting price gaps.
• Adverse selection can make passive liquidity provision unprofitable when fees fail to cover losses.
• Optimal fees balance attracting trading volume against earning revenue and mitigating arbitrage losses.
• The study finds fees are relatively stable in normal conditions but should rise during very high volatility.
• The proposed threshold-style fee schedule is supported by simulations and market data calibration.

Tags

# Optimal Fees for Liquidity Provision in Automated Market Makers


# Optimal Fees for Liquidity Provision in Automated Market Makers









Passive liquidity providers (LPs) in automated market makers (AMMs) face losses due to adverse selection (LVR), which static trading fees often fail to offset in practice. We study the key determinants of LP profitability in a dynamic reduced-form model where an AMM operates in parallel with a centralized exchange (CEX), traders route their orders optimally to the venue offering the better price, and arbitrageurs exploit price discrepancies. Using large-scale simulations and real market data, we analyze how LP profits vary with market conditions such as volatility and trading volume, and characterize the optimal AMM fee as a function of these conditions. We highlight the mechanisms driving these relationships through extensive comparative statics, and confirm the model's relevance through market data calibration. A key trade-off emerges: fees must be low enough to attract volume, yet high enough to earn sufficient revenues and mitigate arbitrage losses. We find that under normal market conditions, the optimal AMM fee is competitive with the trading cost on the CEX and remarkably stable, whereas in periods of very high volatility, a high fee protects passive LPs from severe losses. These findings suggest that a threshold-type dynamic fee schedule is both robust enough to market conditions and improves LP outcomes.

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.