Loss-versus-rebalancing with external proportional transaction costs

Abstract

We study liquidity provision in automated market makers when trading in the external market incurs proportional transaction costs. We consider both separately collected fees and fees retained in reserves. The benchmark is a self-financing strategy holding the same total risky inventory and trading at the external bid and ask. Under continuous external prices and pure arbitrage, the pool and benchmark have identical liquidation wealth whenever the pool fee or the external spread is positive. Thus loss-versus-rebalancing relative to this transaction-cost benchmark is zero, even without a pool fee if the external spread is positive. We then construct retained-fee utility-indifference pools that implement admissible decreasing inventory schedules, and geometric mean pools that implement feasible constant no-trade boundaries for portfolio weights. These results offer an investment interpretation of liquidity provision: by choosing the pool design, a liquidity provider can specify a trading strategy whose rebalancing is carried out by arbitrageurs.