AMM Fee Optimization: DeFi Pools Lose Half of Their Value in Arbitrage

A new study by the MEV-X research team in collaboration with academic partners from HSE University highlights a problem affecting every liquidity pool in DeFi: the AMM fee optimization applied to arbitrage after a swap. The research shows that almost every trade shifts the price of a pool relative to the reference market, creating an arbitrage window that is currently exploited mainly by external parties, leaving value on the table that liquidity providers could capture.

Summary

• Key Points
• Micro inefficiencies in DeFi markets and arbitrage opportunities
  • What is the displacement value in AMMs
  • Impact of arbitrage fees on market efficiency
• Theoretical limits of fee structures in AMMs
  • What is the value of displacement at zero fees
  • Percentage of value captured by constant-product AMMs through fees
• Liquidity providers and arbitrageurs: converging roles with internal atomic arbitrage
  • Implementation with atomic hooks
  • Fee structure and execution dynamics
• FAQ
  • What generates arbitrage opportunities in DeFi markets?
  • Why does applying a fee on arbitrage reduce the total displacement value?
  • How can an AMM maximize liquidity provider revenues from arbitrage?
  • What is the role of AMM hooks in AMM fee optimization?

Key Points

• DeFi markets exhibit micro inefficiencies that open arbitrage opportunities after almost every swap
• The maximum simulated displacement value is 24.75, achieved only at zero fees on arbitrage
• Constant-product AMMs like Uniswap V2 capture at most about 50% of the theoretical value through fees
• At the fee that maximizes revenues (around 0.50%), the pool captures only 49.94% of the value, equivalent to 12.36 units
• The proposed solution is to internalize arbitrage with atomic hooks, eliminating value dispersion.

Micro Inefficiencies in DeFi Markets and Arbitrage Opportunities

Every retail swap shifts the price of a pool relative to the external benchmark, generating a displacement that an arbitrageur can close for profit. The study defines this phenomenon as displacement value: the sum of the arbitrageur's profit and the fee collected by the pool on the arbitrage operation.

What is the Displacement Value in AMMs?

The displacement value represents everything that market inefficiency releases, regardless of who intercepts it. In the simulation conducted by the researchers, the maximum observed value is 24.75, achieved exclusively when the arbitrage fee is zero: in that case, the entire amount goes to the arbitrageur.

Impact of Arbitrage Fees on Market Efficiency

As soon as the fee rises above zero, part of the value is not transferred to anyone: it simply remains unrealized. At a fee of 0.9901%, arbitrage is no longer profitable, the pool earns nothing, and the price distortion remains uncorrected.

Theoretical Limits of Fee Structures in AMMs

Constant-product AMMs, such as Uniswap V2, encounter a theoretical ceiling around 50% of the displacement value that can be captured through fees, and in actual market practice, they do not even reach that threshold.

What is the value of zero-fee displacement? {#What_is_the_value_of_zero-fee_displacement}

At the optimal fee to maximize revenues, around 0.50% in the simulation, the pool extracts 12.36 units, equivalent to 49.94% of the theoretical maximum. At the conventional fee of 0.30%, however, the pool collects 10.42 units (42.08% of the maximum) while the arbitrageur still realizes a profit of 12.08 units.

Percentage of value captured by constant-product AMMs through fees {#Percentage_of_value_captured_by_constant-product_AMMs_through_fees}

The total available value decreases monotonically with each increase in fees: at the threshold that maximizes fee revenues, the overall value has already dropped to 18.47, or 74.62% of the maximum. The remaining 25.38% remains locked in the pool as unclosed displacement because arbitrage stops before the price is brought back into equilibrium. The same dynamic has been verified across nine market combinations and six different AMM architectures, including Balancer, Curve, Trader Joe, and DODO, with peak fee revenues ranging from 47.1% to 50% of the maximum depending on the size of the displacement.

Liquidity providers and arbitrageurs: converging roles with internal atomic arbitrage {#Liquidity_providers_and_arbitrageurs_converging_roles_with_internal_atomic_arbitrage}

The solution identified by researchers is to merge the role of the liquidity provider with that of the arbitrageur, in order to capture the entire value of displacement without ceding it to external parties.

Implementation with atomic hooks {#Implementation_with_atomic_hooks}

Through AMM hooks, the pool performs an atomic and internal arbitrage operation immediately after the user's swap, within the same transaction. There is no longer a time window that an external researcher can exploit, and there is no competition for the right to execute the operation nor risk of dispersion to builders through priority fee bidding.

Fee structure and execution dynamics {#Fee_structure_and_execution_dynamics}

The zero fee applies only to the arbitrage operation initiated by the pool: retail traders continue to pay the normal fee, which remains the source of revenue for the liquidity provided. Internalizing the rebalancing not only adds revenue but also reduces the price divergence generated by the initial swap, bringing the pool closer to its starting state compared to what would happen with external arbitrage subject to positive fees.

FAQ {#FAQ}

What generates arbitrage opportunities in DeFi markets? {#What_generates_arbitrage_opportunities_in_DeFi_markets}

Almost every swap shifts the price of a pool relative to the reference market, creating micro-inefficiencies that open up arbitrage opportunities.

Why does applying a fee on arbitrage reduce the total displacement value? {#Why_does_applying_a_fee_on_arbitrage_reduce_the_total_displacement_value}

A positive fee on arbitrage lowers the displacement value because part of the opportunity remains unrealized: the arbitrageur is disincentivized from fully closing the price imbalance.

How can an AMM maximize liquidity providers' revenues from arbitrage? {#How_can_an_AMM_maximize_liquidity_providers_revenues_from_arbitrage}

By applying a zero fee on arbitrage and internalizing the operation atomically, merging the role of the liquidity provider with that of the arbitrageur.

What is the role of AMM hooks in optimizing AMM fees? {#What_is_the_role_of_AMM_hooks_in_optimizing_AMM_fees}

AMM hooks perform atomic internal arbitrage without leakage to MEV, capturing arbitrage value directly in favor of liquidity providers.

Content created with the assistance of artificial intelligence and human editorial review.