Original title: "The Reason Why LPs Lose More Money Than You Think"
Author: @G_Gyeomm
Compiled by: Peisen, BlockBeats
Editor’s Note: This article takes an in-depth look at two innovative DEX mechanisms, CoW AMM and Bunni V2, which aim to address the profitability risks faced by LPs and create value in areas that CEX cannot provide.
As these mechanisms continue to improve, DEX can not only provide unique value in terms of liquidity provision and profit distribution, but also internalize the value of the protocol and avoid interference from external arbitrageurs. This article summarizes the significance of these attempts and points out that DEX has a great potential in providing liquidity and profit distribution. Advantages in liquidity and profit sharing, and how they improve sustainability by internalizing protocol value.
Regardless of the uncertainty in short-term market sentiment, there is one indicator that makes us optimistic about the long-term prospects of blockchain or the on-chain ecosystem, and that is the recent activity of DEX. Currently, the transaction volume of DEX has reached the highest level since the birth of blockchain. According to The Block, as of August 2024, DEX’s spot trading volume accounted for about 14% of CEX, and according to DeFilama, the transaction volume through DEX in the past 24 hours was about US$7 billion.
As we have seen in the past, when the FTX incident occurred, DEX usage increased due to increased concerns among market participants about custody risks, and short-term events often temporarily boost DEX usage. However, unlike these temporary increases, our The increase in DEX usage seen so far shows a continuing trend. This steady upward trend in DEX usage compared to CEX can be interpreted as a result of DEXs continuing to improve and make significant progress in terms of usability.
Source: DEX to CEX spot trading volume (%)
Among these developments, the one I want to highlight today is liquidity provision (LPing) in automated market maker (AMM) mechanisms, especially the xy=k based constant product market maker (CPMM) adopted by most DEXs. Adequate liquidity helps provide a smooth trading environment by minimizing slippage, so aligning the incentives between the protocol and liquidity providers (LPs) to maintain a continuously increasing LPing status is considered the core of DEX. In other words, DEX must ensure that LPs achieve sufficient profitability.
However, a problem has recently emerged in AMM DEX, that is, "LP lost more funds than expected." The entity that caused the LP loss was external participants such as arbitrageurs. As the value generated within the protocol is continuously extracted by external entities , the value flowing to the protocol operating participants is reduced. Therefore, the risks in liquidity provision, such as LVR (rebalancing loss), have become an important topic, and those DEXs that can eliminate such risks and quickly adopt newly developed technologies have once again attracted attention. Next, we will explore these various DEX attempts and reveal their significance in the recent DeFi protocol trend.
An attempt to mitigate LP profitability risk
COW Protocol: AMM that captures MEV
Source: CoW Protocol Docs
CoW Swap provides a swap service that protects traders from MEV (maximum extractable value) attacks such as front-running, tailgating, or sandwich attacks through an off-chain batch auction system. In CoW Swap, traders do not directly Instead of settling transactions on-chain, the intention to trade tokens is submitted to the protocol. When the transactions of these traders are packaged into an off-chain batch, a third-party entity called Solver collects the tokens from AMMs (such as Uniswap, Balancer) and The best trading path is found in channels such as DEX aggregators such as 1inch. This allows traders to be protected from the impact of MEV and trade at the best price.
Source: CoW Protocol Docs
This batch auction transaction mechanism based on Solver intervention enables CoW Swap to specifically prevent the value of external traders from being extracted. Based on this mechanism, CoW Swap further launched CoW AMM, which aims to not only protect traders' transactions from MEV The CoW AMM is proposed as a MEV-capturing AMM that aims to eliminate the LVR (rebalancing loss) caused by arbitrageurs.
Source: Delphi Digital
Here, LVR (rebalancing loss) is a risk management indicator that quantifies the arbitrage opportunities brought about by the difference between the asset price inside the AMM and the external market price due to asset price fluctuations during the period when LP provides liquidity. the losses caused.
In other words, while Impermanent Impermanent Loss, another risk of LP, only considers the opportunity cost that LP may experience between the start and end points of the LP position due to asset price fluctuations, LVR represents the LP’s The ongoing costs borne by the arbitrageur’s counterparty over the entire period of providing liquidity. This requires a more detailed explanation, but the core point to emphasize here is that liquidity providers face the risks posed by external arbitrageurs. Unfavorable trading conditions.
To address this problem, CoW AMM is designed to protect LPs from external arbitrageurs and capture MEV internally. In CoW AMM, Solvers compete to bid every time an arbitrage opportunity arises to gain the right to rebalance the CoW AMM pool. The process is as follows:
LP deposits liquidity into the CoW AMM pool.
When arbitrage opportunities arise, Solvers compete to bid to rebalance the CoW AMM pool.
The solver who can leave the most Surplus in the pool gets the right to rebalance the pool. Here, Surplus refers to the quantitative result of the degree to which the AMM curve moves up. In simple terms, it is to provide the most favorable trading conditions for LPs. Excess funds left in the liquidity pool. For a detailed explanation of Surplus capture AMM, please refer to this article .
In this way, CoW AMM internally captures the arbitrage value extracted by MEV robots in existing CPMMs, eliminating the LVR risk faced by LPs, while LPs use Surplus as an incentive to provide liquidity. In other words, compared to existing CPMMs Different from this, CoW AMM can use MEV as a source of income, not just transaction fees.
Source: Dune (@cowprotocol)
Similar to CoW Swap, this CoW AMM uses a single price for token purchases and sales in a specific batch, and ultimately forms a block with one batch. Therefore, it can fundamentally prevent MEV based on price differences. For example, arbitrage, and minimizing LP’s LVR by not providing stale AMM prices that do not reflect price fluctuations to external arbitrageurs.
Bunni V2: Hooks out of scope
Bunni V2 leverages Uniswap V4’s “Out of Range Hooks” as another way to increase LP profitability. Hooks is one of the architectural upgrades of the upcoming Uniswap V4, which allows for the creation of new LPs based on various usage methods (dynamic rates, TWAMM, Out of scope, etc.) Modularize and customize Uniswap's liquidity pool contract.
Bunni V1 was originally a liquidity provider derivatives (LPD) protocol that, together with Gamma and Arrakis Finance, improved upon the limitations of centralized liquidity proposed by Uniswap V3. However, with the launch of V2, Bunni has expanded its offering by combining a variety of Hooks" and built their own DEX.
Pooled liquidity refers to a liquidity provision method that allows LPs to directly determine arbitrary price ranges for LPing to improve the capital efficiency of liquidity provision positions. Although this type of pooled liquidity improves capital efficiency, its limitation is that LPs must The range of liquidity provided is continuously adjusted to match the changing market prices. Therefore, Bunni provides a solution that automatically manages the range of liquidity provided when LPs entrust funds.
Source: X (@bunni_xyz)
Out of Range Hooks is a new attempt to improve capital efficiency by interoperating idle liquidity with external protocols instead of re-adjusting the liquidity provision range when idle liquidity exceeds the current market price range. It invests in lending protocols and funding pools that can generate interest income (such as Aave, Yearn, Gearbox, Morpho, etc.), which not only provides LP with transaction fees from LPing, but also brings additional returns.
Of course, since Bunni’s attempt is still in the testing phase, possible trade-offs in the future (such as increased contract risk due to liquidity interoperability or reduced liquidity required for AMM swaps) will need to be closely observed. These trade-offs may be at the expense of capital efficiency.
Summarize
Unique advantages of DEX
Looking back at the current market share of DEX compared to CEX mentioned in the introduction, we will raise an important question: Why should we use DEX instead of CEX? From an objective point of view, considering only the convenience and rich liquidity of CEX, It’s hard to find a compelling reason to use DEX. Even if DEX usage keeps trending upward, 14% usage compared to CEX is, frankly, not very large.
The FTX bankruptcy incident reminded market participants of the risks of custodial exchanges and stimulated the use of DEX in the short term, but this is only a temporary replacement. Therefore, as a way to gradually expand the market share of DEX, we should continue to try to create DEX-unique native Value proposition, which cannot be experienced in CEX.
Source: AAVEnomics Update
In this regard, liquidity provision (LPing) and profit sharing mechanisms are very important as unique values of DEX. LPing is not only a basic condition for providing a smooth trading environment, but also a passive income generation path provided by LPing, which can also be used as a way to convert CEX liquidity into profit sharing. The profit sharing mechanism can become the starting point of a self-sustaining economic system or token economy, in which participants can earn profits based on the decentralized Tokens in the protocol incentivize contributions and earn rewards, which may be the most ideal way to maximize the utility of blockchain and cryptocurrency.
Internalizing protocol value becomes increasingly important
When the unique value that DEX can provide is reflected in the liquidity provision and profit distribution mechanism, it becomes particularly important to internalize the value previously extracted from external entities (arbitrageurs or various MEVs). The DEX functions examined in this article are also for To achieve this goal. CoW AMM captures MEV internally to eliminate LP risk, while Bunni V2’s out-of-scope functionality maximizes LP profitability by interoperating liquidity within the AMM pool. Although not mentioned in this article, some recent DeFi protocols have been based on oracles. Attempts are being explored to internalize OEV (Oracle Extractable Value) profits from price data.
Moreover, the importance of this is further highlighted as the mechanism by which the protocol redistributes the value gained from the protocol to the protocol participants has recently been re-emphasized. In fact, Aave Protocol has proposed a new AAVEnomics plan to repurchase the protocol revenue | _2024111120230_| and distributed to $AAVE holders. Meanwhile, Uniswap’s fee switch was recently re-ignited, and Aevo also announced that it would repurchase AEVO.
As DeFi protocols try to introduce value distribution mechanisms, the sustainable revenue model of the protocol and the value accumulated within the protocol become particularly important. For example, if Uniswap proposes to distribute transaction fees to UNI holders, it must be completely different from the previous LP A portion of the transaction fees obtained are shared with UNI holders. In this case, in order to redistribute value to protocol participants, the protocol needs to accumulate more value than before, which also highlights the need to internalize the value previously collected from external entities. Importance of value extracted.
In this context, protocols like CoW AMM and Bunni V2, which we discussed today, are worth paying close attention to by proposing differentiated liquidity provision methods or developing mechanisms to return the value gained by the protocol to ecosystem participants. In addition to these, various protocols are also developing attempts to improve LPing, such as Osmosis's Protorev to prevent tailing transactions, or Smilee Finance's "impermanent return" as a way to hedge against the risk of Impermanent Loss. DeFi protocols create their own The process of unique value, which cannot be provided through CEX or CeFi, will continue to be an important observation point for gradually increasing DEX activity in the future.
