Who Pays for Arbitrage? A Deep Dive into AMMs and Liquidity Asymmetry

Abstract

Arbitrage between two constant product liquidity pools benefits the trader but imposes a cost on liquidity providers. This cost, known as impermanent loss or loss-versus-rebalancing (LVR), is borne unevenly depending on each pool’s liquidity depth. Pools with less liquidity pay more of the price adjustment, effectively funding the arbitrageur’s profit. This dynamic explains why centralized exchanges (CEXs) with massive liquidity can efficiently arbitrage decentralized exchanges (DEXs), leaving DEX liquidity providers to absorb most of the cost.