Dynamic fee capture by active liquidity providers significantly reduces passive reserves during volatile trading periods. When active providers capture the majority of high-volume transaction fees, less fee revenue is reinvested into passive liquidity, accelerating the depletion of passive pools. During Play, Passive Reserve Pool falls from 94 to 33 by step 15 as active rebalance speed increases, using these illustrative values to show the underlying system dynamics.
Key takeaways
- Raising Active Rebalance Speed from 2 to 5 reduces Passive Reserve Pool to 33 at step 15 compared to 94 in the baseline.
- Increasing Market Volatility Rate from 1 to 4 causes Passive Reserve Pool to fall to 6 at step 15 because adverse selection drains static reserves.
- Passive Reserve Pool in this model requires sufficient fee inflows to offset losses from Adverse Selection Drain, making volatility the first risk factor to evaluate.
How do active rebalancing and volatility drain passive liquidity?
A decentralized finance depositor or protocol designer must decide whether to leave liquidity unattended in an automated market maker pool or actively manage price bounds when trading activity shifts. In this playable model, the illustrative baseline leaves Passive Reserve Pool at 94 at step 15, but accelerating active rebalancing cuts that outcome to 33, and raising market volatility drops it to 6. All numerical values reported here are illustrative model values.
When passive participants commit capital to static price bands, active algorithmic providers can reposition their ranges around current prices to capture incoming trade volume. That mechanism diverts swap fees away from the passive stock, leaving static reserves exposed to adverse selection whenever market prices jump.
What happens when you adjust the model levers?
The first lever is Active Rebalance Speed, which sets how quickly active managers adjust price ranges. In the baseline setting with this lever at 2, Passive Reserve Pool reaches 94 at step 15. When this lever is raised to 5, Passive Reserve Pool finishes much lower at 33.
Early in the Play, Passive Reserve Pool rises to 101 at step 1 under the baseline. With Active Rebalance Speed set to 5, the stock drops to 98 at step 1 and falls to 75 by step 8, showing steady diversion of trade fees.
The second lever is Market Volatility Rate, which sets the strength of price swings. In the baseline with Market Volatility Rate set at 1, Passive Reserve Pool ends at 94 at step 15. Raising this lever to 4 pushes the final stock down to 6.
The two trajectories part immediately. Under baseline volatility, Passive Reserve Pool stays at 103 through step 5, but raising Market Volatility Rate to 4 pulls it down to 73 at step 5 and 55 by step 8 as arbitrage losses compound.
The card also has three more sliders. Collect sets how much fee revenue flows from Trading Fees into Passive Reserve Pool each step: 8 in the baseline, adjustable from 0 to 50. Passive Reserve Pool sets the capital held by passive liquidity providers before step 1: 100 in the baseline, adjustable from 0 to 1000. Active LP Capital sets the capital held by dynamic liquidity providers before step 1: 20 in the baseline, adjustable from 0 to 500.
How does the liquidity balance shift across the system?
Trading Fees acts as a source that generates gross swap income from daily trade volume. These fees flow outward into two competing stores: Passive Reserve Pool, which holds deposits from passive market participants, and Active LP Capital, which accumulates the earnings of active managers.
Active Rebalance Speed governs how much of the fee flow is directed into Active LP Capital before passive deposits can receive their share. At the same time, Market Volatility Rate feeds the Adverse Selection Drain, a sink that pulls capital out of Passive Reserve Pool whenever price movements allow informed traders to extract value.
Because passive depositors keep their capital fixed across wide price bands, higher volatility accelerates the outflow to the drain. If active participants also capture most of the incoming fees, Passive Reserve Pool loses the inflows needed to offset those ongoing losses.
What do these model results mean for liquidity providers?
In this model, passive liquidity provision depends on steady fee reinvestment to withstand price movements. When active liquidity managers rebalance rapidly, they take the fee flow that would otherwise replenish passive balances, turning a stable position into a shrinking reserve.
A liquidity allocator looking at these dynamics should first check the rate of volatility in the market. In this model, high volatility alone can reduce Passive Reserve Pool from 94 down to 6, meaning adverse selection creates a severe drag even before accounting for fee competition from active strategies.
What does the model leave out?
Real systems are more complicated than any model, and this diagram relies on explicit simplifications. It assumes one time step of Play represents one trading day, holding trade fee generation and volatility rates constant throughout the sequence.
Passive depositors keep their capital completely static across all steps, while active participants follow a fixed rebalancing speed without adjusting their behavior over time. The model tracks only the defined stocks and flows, omitting external interactions between separate trading pools.
Where does the topic come from?
This playable model was inspired by the publication titled Not All LPs Are Equal: The Active-Passive Gap in Automated Market Maker Liquidity Provision, published by arXiv on 7 October 2026. This essay and its numbers present the model's own illustrative scenario based on that research.
How can you test these dynamics yourself?
You can explore these trade-offs directly by moving the levers in the playable model. Try adjusting Market Volatility Rate and Active Rebalance Speed across different settings to watch how the balance between Active LP Capital and Passive Reserve Pool evolves over time.
The parts of the model
The question it asks: How does dynamic fee capture by active liquidity providers affect passive liquidity pool reserves under varying trade volatility?
- Trading Fees · Source
- Generates gross swap fees from daily market trade volume.
- Passive Reserve Pool · Pool
- Holds liquidity provided by passive automated market maker depositors.
- Adverse Selection Drain · Sink
- Absorbs capital lost by passive reserves to informed arbitrage during price shifts.
- Active LP Capital · Pool
- Stores accumulated capital and fee share captured by active liquidity managers.
- Active Rebalance Speed · Lever
- Controls how rapidly active providers adjust price ranges to intercept volume.
- Market Volatility Rate · Lever
- Sets the intensity of price swings driving arbitrage and adverse selection.
Assumptions and limits
- One time step of Play represents one trading day.
- Passive LPs keep capital fixed in the AMM while active LPs continuously update price ranges.
- All numerical values are illustrative.
A teaching model with illustrative values; each Play is a scenario, not a forecast.
Sources
- arXiv (arxiv.org)
Thank you to arXiv for use of its open access interoperability.
About this model
Machinations makes these models with AI from a public source, and each one is a teaching scenario: its numbers are illustrative values chosen for the model, not measurements or forecasts. You can open this diagram in the Community to remix it and change it.