Author: @G_Gyeomm
Compiled by: TechFlow
Regardless of the uncertainty in short-term market sentiment, recent activity on decentralized exchanges (DEXs) gives us reason to be optimistic about the long-term future of blockchain or on-chain ecosystems. Currently, DEX trading volumes have reached their highest levels since the birth of blockchain. According to The Block, as of August 2024, DEX spot trading volume accounts for about 14% of centralized exchanges (CEX), while according to DeFilama, the trading volume executed through DEXs in the past 24 hours was about $7 billion.
In the past, FTX events have increased custody risk for market participants, leading to an increase in DEX usage, and such short-term events often temporarily increase DEX usage. However, the increase in DEX usage we are currently seeing is a continuing trend. This steady rise in DEX usage compared to CEX can be seen as the result of DEX’s continuous improvements and significant progress in aspects such as usability.
Source: Spot trading volume of DEX and CEX (%)
Among these developments, the DEX component I want to highlight today is the liquidity provision (LPing) mechanism of the automated market maker (AMM), especially CPMM (Constant Product Market Maker), which is adopted by most DEXs, and trades are executed through xy=k. Sufficient liquidity provides a smooth trading environment by minimizing slippage, so DEX must align incentives between the protocol and liquidity providers (LPs) to maintain a continuous state of liquidity provision, which is regarded as the core of DEX. In other words, DEX must ensure that LPs have sufficient profitability.
However, a recent problem in AMM DEX is "LP's losses are greater than expected". The entities that cause LP losses are external parties, such as arbitrageurs. As the value generated in the protocol is continuously extracted by external entities, the value obtained by participants in the operation of the protocol decreases. Therefore, the risks of liquidity provision, such as LVR (loss and rebalancing), have become an important topic, and DEXs that eliminate such risks and quickly adopt newly developed technologies have once again received attention. Next, we will explore the various attempts of these DEXs and clarify their importance in the recent DeFi protocol trend.
1. Background - Attempts to Mitigate LP Profitability Risk
1.1 COW Protocol - MEV Captures AMM
Source: CoW protocol documentation
CoW Swap provides a swap service that protects traders from MEV attacks such as front-end, back-end, or pincer attacks through an offline batch auction system. In CoW Swap, instead of settling trades directly on-chain, traders submit their intention to trade tokens to the protocol. When these traders' trades are packaged into an offline batch, a third-party entity called a Solver looks for the best trading path from AMMs (such as Uniswap, Balancer) and DEX aggregators (such as 1inch), etc. This allows traders to be protected from MEV and trade at the best price.
Source: CoW protocol documentation
CoW Swap focuses on preventing value extraction by external traders through batch auction-based transactions and solver intervention. Based on this mechanism, CoW Swap introduces CoW AMM as the next step to protect traders' transactions from MEV, while also protecting LP. CoW AMM is proposed as a MEV-capturing AMM that eliminates LVR caused by arbitrageurs.
Source: Delphi Digital
Here, LVR (Loss and Rebalance) is a risk management metric that quantifies the loss that LPs incur in the LP state due to the difference between the asset price inside the AMM and the external market price due to asset price fluctuations. In other words, while impermanent loss is another risk of liquidity provision, considering only the opportunity cost that LPs may experience due to asset price fluctuations, LVR represents the ongoing cost of LPs assuming the role of arbitrageur counterparty throughout the LP period. This requires a more detailed explanation, but the fundamental issue that needs to be emphasized here is that liquidity providers are subject to adverse trading conditions from external arbitrageurs.
CoW DAO | Don't get milked: CoW AMM uses a functional maximization AMM (FM-AMM) design that uses batch auctions to capture surplus for protected liquidity pools. The solver that provides the highest surplus wins the right to rebalance the pool, thereby capturing LVR for the pool.
To solve this problem, CoW AMM is designed to protect liquidity providers (LPs) from interference from external arbitrageurs and capture MEV internally. In CoW AMM, when arbitrage opportunities arise, Solvers compete to bid for the right to rebalance the CoW AMM pool. The specific process is as follows:
LP deposits liquidity into the CoW AMM pool.
When arbitrage opportunities arise, Solvers bid to rebalance the CoW AMM pool.
The Solver who leaves the most surplus in the pool gets the right to rebalance the pool. Here, surplus refers to the degree to which the AMM curve moves upward. In simple terms, it is the remaining funds in the liquidity pool, which are retained by providing the most favorable trading conditions for LPs. For a detailed explanation of surplus capture AMM, please refer to this article.
Through this mechanism, CoW AMM is able to internally capture the arbitrage gains extracted by the MEV robots in the existing CPMM, eliminating the LVR risk faced by LPs, while LPs will receive surplus as an incentive for providing liquidity. In other words, unlike existing CPMMs, CoW AMMs can use MEV as a source of income instead of relying solely on transaction fees.
Source: Dune (@cowprotocol)
This CoW AMM is similar to CoW Swap, applying a single price for token buy and sell transactions within a specific batch, and ultimately adopting a method for a batch to form a block. Therefore, it is able to fundamentally prevent MEV based on price differences, such as arbitrage, and minimize the LVR of LP by not providing outdated AMM prices that do not reflect price fluctuations to external arbitrageurs.
1.2 Bunni V2 - Out of scope hook
Bunni V2 leverages Uniswap v4’s out-of-range hooks as another way to improve LP profitability. The hooks here are one of the architectural upgrades of the upcoming Uniswap V4, allowing Uniswap’s liquidity pool contracts to be customized as modules based on different usages (dynamic fees, TWAMM, out-of-range, etc.).
Bunni V1 was originally a liquidity provision derivative (LPD) protocol that was developed in conjunction with Gamma and Arrakis Finance to improve the limitations of concentrated liquidity proposed by Uniswap V3. However, after the release of V2, it built its own DEX by combining various hook usage features, including out of range hooks. Here, concentrated liquidity is a liquidity provision method that allows LPs to directly determine an arbitrary price range for liquidity provision to improve the capital efficiency of the liquidity provision position. While this concentrated liquidity improves capital efficiency, its limitation is that LPs must constantly adjust the range of liquidity provision to match changing market prices, so Bunni provides a solution that automatically manages the range of liquidity provision when LPs entrust their funds.
Source: X (@bunni_xyz)
The out-of-range hook is a new attempt to improve capital efficiency by interoperating idle liquidity with external protocols, rather than re-adjusting the scope of liquidity provision when idle liquidity exceeds the current market price range. By depositing idle liquidity into lending protocols and vaults that can generate interest income, such as Aave, Yearn, Gearbox, Morpho, etc., it provides LPs with additional returns in addition to transaction fees from liquidity provision. Of course, since Bunni's attempt is still in the testing phase, it is necessary to closely observe possible trade-offs in the future, such as increased contract risks due to liquidity interoperability or exhaustion of liquidity required for AMM exchanges, which may come at the expense of capital efficiency.
2. Key points
2.1 Advantages that DEX can provide that CEX cannot
When summarizing the current status of DEX market share and CEX, an important question emerges: Why should we use DEX instead of CEX? From an objective point of view, considering only the convenience and rich liquidity of CEX, it seems difficult to find a convincing reason to use DEX. Even if the usage of DEX keeps rising, 14% market share is frankly not that big.
The FTX bankruptcy incident reminded market participants of the risks of custodial exchanges and stimulated the use of DEX in the short term, but it is only a temporary substitute. Therefore, as a way to gradually expand the market share of DEX, it is particularly important to continue to try to create a unique value proposition of DEX, which cannot be experienced in CEX.
Source: AAVEnomics Update
In this regard, liquidity provision (LPing) and profit redistribution mechanisms are very important as unique values of DEX. LPing is not only a necessary condition for providing a smooth trading environment, but also provides another motivation for market participants to contact DEX through the passive income generation path provided by LPing. At the same time, the profit redistribution mechanism may be the starting point of a self-sustaining economic system or token economy, where participants contribute and are rewarded according to token incentives on decentralized protocols, which may be an ideal way to maximize the utility of blockchain and cryptocurrency.
2.2 Internalizing protocol value becomes increasingly important
When the unique value of DEX is reflected in the liquidity provision and profit redistribution mechanism, it becomes particularly important to internalize the value previously extracted from external entities (such as arbitrageurs or various MEVs). The DEX features discussed in this article are designed to solve this problem. CoW AMM captures MEV internally to eliminate LP risk, while Bunni V2's out-of-scope function interoperates liquidity within the AMM pool to maximize LP profitability. Although not mentioned in this article, some recent DeFi protocols receive price information based on oracles and explore attempts to internalize OEV (Oracle Extractable Value) profits.
Furthermore, with the recent renewed emphasis on mechanisms to redistribute value gained by the protocol to protocol participants, its importance has been further highlighted. In fact, the Aave protocol proposed the new AAVEnomics, which repurchases $AAVE through protocol revenue and distributes it to $AAVE holders. Meanwhile, Uniswap’s fee switch has also recently received renewed attention, and even Aevo announced that it will repurchase $AEVO.
As DeFi protocols attempt to introduce mechanisms to redistribute value, the sustainable revenue model of the protocol and the value accumulated internally become more important. For example, if Uniswap distributes trading fees to $UNI holders through a proposal, it will need to share part of the trading fees that were previously captured entirely by LPs with $UNI holders. In this case, more value needs to be accumulated within the protocol in order to redistribute value to protocol participants, and the importance of internalizing the value previously extracted from external entities is also emphasized.
From this perspective, differentiated liquidity provision methods like those proposed by CoW AMM and Bunni V2, which we discussed today, or the development of mechanisms to return the value obtained by the protocol to ecosystem participants are attempts worthy of close attention. In addition, various protocols are also developing attempts to improve LPing, such as Osmosis's Protorev to prevent run-backs, or Smilee Finance's "impermanent returns" as a way to hedge against the risk of impermanent loss. The process of DeFi protocols creating unique value through these attempts will continue to be an important focus of the gradual increase in DEX activity.
