Adverse Selection in AMMs

Adverse selection in Automated Market Makers happens when liquidity providers are systematically traded against by participants with better information. This occurs because AMMs typically use static pricing formulas that do not instantly reflect external market prices.

Arbitrageurs can observe price changes on centralized exchanges and execute trades on the AMM before the price has adjusted, capturing the difference as profit at the expense of the liquidity providers. This effectively means that liquidity providers are providing a free option to the arbitrageurs.

To mitigate this, some protocols implement dynamic fees or rely on oracle-based pricing to narrow the gap. Understanding this dynamic is essential for designing sustainable liquidity pools and improving the efficiency of decentralized trading.