How DeFi punishes its own market makers—and what we must build to protect them

If liquidity is the lifeblood of DeFi, then liquidity providers—LPs—are the beating heart.

They’re the ones putting real capital on the line so trades can flow, prices can form, and protocols can scale.

And while LPs earn yield, fees, and even governance power in return—too many have also earned a hard lesson:

  • The APR looks juicy…
  • The strategy seems simple…
  • And then out of nowhere—boom.

Some manipulation, a flash crash, or a bug rips through the protocol—and it’s the LPs left eating the loss.

Now, to be fair—not all DeFi protocols leave LPs hanging.

Some platforms have added dynamic fees, vault segmentation, even insurance funds.

But the truth is: in too many systems, LPs still absorb asymmetric risk with no control and no visibility.

And that’s a problem we can—and should—fix.

Who We’re Really Talking About

Let’s define the players here:

  • LPs (Liquidity Providers) are individuals or entities who deposit tokens into AMMs, lending pools, or vaults to earn yield while providing trading capital.

They are the decentralized market makers of Web3.

This is about empowering LPs—giving them the tools TradFi desks have used for decades to survive volatility.

When LPs Absorb Risk Without a Say

Let’s be real—risk is part of the game. LPs know that.

But what’s not cool?

Being asked to take risk without being given the tools to manage it.

In AMMs, LPs face impermanent loss—a tax on their capital when prices shift unevenly.

In vaults and derivative protocols, they can inherit toxic directional risk, or absorb losses from leveraged traders playing games with price feeds and thin books.

And when it goes wrong?

Just Ask Hyperliquid

We broke this down in Article 1 in this series: a trader on Hyperliquid opened a massive short on JellyJelly, manipulated the price down, and walked off with a fortune.

The vault—the Hyperliquidity Provider—was the counterparty.

It didn’t hedge. It didn’t limit exposure.

It just executed… and bled.

This wasn’t a glitch. It was a design flaw.

Now to be clear: that’s not every protocol.

But it’s still too common. 

And when LPs get burned, it undermines trust in the whole system.

TradFi Market Makers Would Never…

Let’s talk about how it should work.

Say Citadel Securities is quoting prices on a mid-cap stock. Suddenly, the order book gets weird. Volume spikes. Price swings explode. Someone’s clearly playing games.

Now imagine Citadel just keeps quoting the same tight spreads.

No widening. No hedging. No exposure limits.

Just eating toxic trades like candy.

That would never happen.

Citadel—and every major TradFi market maker—has:

  • Real-time volatility filters to adjust spreads,
  • Position and exposure limits per asset and client,
  • Delta-neutral hedging strategies to flatten directional risk,
  • Surveillance systems to flag manipulation in real time,
  • And automated risk-off protocols when things go sideways.

Because their job isn’t just to quote prices.

It’s to protect the book.

DeFi needs that same DNA—just encoded in smart contracts instead of risk managers.

The Blueprint for LP Protection

So how do we stop using LPs as passive cannon fodder?

Here are a few thoughts.

Vault Segmentation

Not all risk is created equal.

Segment vaults so LPs can choose between:

  • Low-volatility pools with stable rewards,
  • High-risk pools with volatile assets and higher upside.

Let them decide the risk they take. Let them price their participation.

🧮 Dynamic Hedging Mechanisms

Vaults should hedge exposure like a pro trading desk.

That means:

  • Inverse asset exposure,
  • Options overlays,
  • Synthetic delta-neutral setups.

Don’t leave LPs naked to directional swings. Build in the buffers.

Position Caps & Risk Filters

  • Cap how much exposure the protocol takes per asset or per trader.
  • Throttle or block trades when internal risk limits are hit.
  • Don’t be afraid to say “no” to a whale trying to steamroll the vault.

Real-Time Vault Analytics

Give LPs a dashboard that actually tells them something.

Show:

  • Exposure by asset,
  • Leverage ratios,
  • Projected drawdowns,
  • Open interest risk zones.

Don’t make them deposit blind.

Protocol-Integrated Insurance Pools

Take a slice of every trade and route it to a safety buffer.

When the black swan flies in, give LPs some compensation. 

It’s not a bailout. It’s a backstop—and it keeps trust intact.

Who’s Already Protecting LPs?

Not every protocol is leaving LPs out to dry. Some of the sharpest teams in DeFi have already started baking protection into their designs:

  • Uniswap v3 introduced concentrated liquidity, allowing LPs to define the price range where they want to provide liquidity—giving them more control over risk and capital efficiency.
  • Balancer lets LPs create custom weight pools (like 80/20 or 95/5) and offers dynamic fees to offset impermanent loss during volatility.
  • Curve Finance specializes in low-volatility pairs (like stablecoins), minimizing impermanent loss through algorithmic curve shaping.
  • Yearn Finance aggregates yield strategies while routing capital through audited vaults with built-in risk parameters and dynamic position management.
  • Maple Finance and Ribbon Finance are experimenting with risk-tranched vaults and option strategies to give LPs tailored exposure and passive protection.
  • Gearbox separates passive LP capital from active trading risk through isolated pools, offering more insulation from user strategies.

These aren’t perfect systems—but they’re evolving fast, and they’re showing us what’s possible when LP protection becomes a first-class design priority.

LPs Are the Market Makers. Treat Them Like It.

DeFi has done an amazing job giving people access to tools Wall Street used to guard like gold.

But if we want the capital to stay—and grow—we need to stop treating LPs like background actors.

They are the liquidity.
They are the risk-sharing partners.
They are the heartbeat of the protocol.

It’s time the architecture reflected that.

The future of DeFi isn’t just higher yields.
It’s smarter risk.

Coming Up Next: Fireproof Vaults

In our next episode, we take this one step further.

We’ll dive into how to build fireproof vaults—multi-layered systems that model volatility, dynamically adjust risk, and execute defense mechanisms like the best hedge funds in the world.

Because if we’re going to replace Wall Street?

We better start building like it.

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Michael Hearne

I’m a serial entrepreneur, and I’ve spent the last 15 years taking companies to new levels, breaking the boundaries of innovation, and triumphing over adversity. My wife, Victoria, and I started our first business in a 2-bed/1-bath apartment with 4 kids, next to a crackhouse. We pushed through setbacks and failures to lift our family out of poverty. Along the way, I’ve learned that my struggles make me stronger. And that being the best version of me is the greatest contribution I can give to the world. It makes me a better husband, and father. It improves my health, energy, and my capacity to serve others. And it has allowed me to build businesses that make the world a better place. Today, I work for passion, to make a difference, and solve real problems in the real world through my business ventures. This little site is where I share the things I’ve learned, and am still learning, on my journey.