From Impermanent Loss to Sustainable Gain: Quantifying Profitability Zones for Liquidity Providers on DEX

TL;DR

This paper models and quantifies profitability zones for liquidity providers on DEXs, analyzing arbitrage interactions and proposing a framework for optimal fee setting to enhance market stability.

Contribution

It introduces a mathematical model for liquidity provider profitability zones on AMM-based DEXs, extending risk assessment and guiding fee strategies.

Findings

Derived bounds on joint revenue of LPs and arbitrageurs

Estimated expected number of blocks until Impermanent Loss occurs

Provided a lower bound on pool fees for desired profitability probability

Abstract

Decentralized Finance (DeFi) is a rapidly evolving segment of blockchain technology that enables a transformative approach to financial services through Web3 applications. By leveraging smart contracts, DeFi allows developers to build flexible and innovative financial instruments. Among the most prominent DeFi primitives by liquidity are decentralized exchange~(DEX) swap protocols~(such as Uniswap, Curve, and Balancer) that facilitate fast token-to-token exchanges. However, new exchange mechanisms also introduce new market inefficiencies that can be systematically exploited by arbitrageurs. This paper focuses on swap protocols based on the Automated Market Maker~(AMM), where the product of reserves is preserved as an invariant. We analyze the interaction between arbitrageurs and AMM liquidity pools and develop a mathematical model grounded in empirical pool configurations. Using this model, we derive bounds on the joint revenue of liquidity providers~(LPs) and arbitrageurs, propose a method to estimate the expected number of blocks until the occurrence of Impermanent Loss~(IL), and obtain a lower bound on the pool fee required to achieve a fixed target probability of staying in the Impermanent Gain (IG) zone within a block. The proposed framework extends existing LP risk-assessment methodologies by quantifying symbiotic profitability zones, providing a principled basis for fee selection that aligns LP-arbitrageur incentives and enhances market stability.