In-depth discussion of DEX mechanism: LP losses are greater than you think

Original author: @G_Gyeomm

Original translation: 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, DEXs can not only provide unique value in terms of liquidity provision and profit distribution, but also internalize protocol value and avoid interference from external arbitrageurs. This article summarizes the significance of these attempts, pointing out the advantages of DEXs in providing liquidity and profit distribution, and how they can improve sustainability by internalizing protocol value.

No matter how uncertain the short-term market sentiment is, there is one indicator that makes us optimistic about the long-term prospects of blockchain or on-chain ecosystems, and that is the recent activity of DEX. Currently, the trading volume of DEX has reached a record high since the birth of blockchain. According to data from The Block, as of August 2024, the spot trading volume of DEX accounts for about 14% of CEX, and according to statistics from DeFilama, the trading volume through DEX in the past 24 hours was about US$7 billion.

As we have seen in the past, short-term events often temporarily boost DEX usage, as market participants’ concerns about custody risk increased during the FTX incident. However, unlike these temporary increases, the increase in DEX usage we are currently seeing shows a sustained trend. This steady upward trend in DEX usage can be interpreted as a result of DEXs continuing to improve and make significant progress in usability compared to CEXs.

Source: DEX to CEX spot trading volume (%)

Among these developments, what I want to highlight today is the liquidity provision (LPing) in the automated market maker (AMM) mechanism, especially the constant product market maker (CPMM) based on xy=k adopted by most DEXs. Sufficient liquidity helps to provide a smooth trading environment by minimizing slippage, so aligning the incentive mechanism between the protocol and the liquidity provider (LP) to maintain a continuously increasing LPing state is considered the core of DEX. In other words, DEX must ensure that LPs obtain sufficient profitability.

However, a problem has recently emerged in AMM DEXs that LPs have lost more money than expected. The entities that cause LP losses are external participants such as arbitrageurs. As the value generated within the protocol is continuously extracted by external entities, the value flowing to protocol operating participants decreases. Therefore, risks in liquidity provision, such as LVR (rebalancing loss), have become an important topic, and DEXs that can eliminate such risks and quickly adopt newly developed technologies have once again attracted attention. Next, we will explore the various attempts of these DEXs 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 settle transactions directly on the chain, but submit their intention to trade tokens to the protocol. When the transactions of these traders are packaged into an off-chain batch, a third-party entity called Solver finds the best transaction path from channels such as AMMs (such as Uniswap, Balancer) and DEX aggregators (such as 1inch). This allows traders to be protected from MEV and trade at the best price.

Source: CoW Protocol Docs

This batch auction trading mechanism based on Solver intervention allows 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 protect not only traders transactions from MEV, but also liquidity providers (LP). CoW AMM is proposed as an AMM that captures MEV, aiming to eliminate LVR (rebalancing loss) caused by arbitrageurs.

Source: Delphi Digital

Here, LVR (rebalancing loss) is a risk management indicator that quantifies the loss caused by arbitrage opportunities caused by the difference between asset prices within the AMM and external market prices due to asset price fluctuations during the period when LP provides liquidity.

In other words, while Impermanent Loss, another LP risk, only takes into account 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 ongoing cost that LP bears as the counterparty to the arbitrageur throughout the period of providing liquidity. This requires a more detailed explanation, but the core point to emphasize here is that liquidity providers face adverse trading conditions brought by external arbitrageurs.

To solve this problem, CoW AMM is designed to protect LPs from external arbitrageurs and capture MEV internally. In CoW AMM, Solvers compete to bid for the right to rebalance the CoW AMM pool every time an arbitrage opportunity arises. 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 that 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 the excess funds left in the liquidity pool by providing the most favorable trading conditions for LPs. 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, unlike existing CPMMs, 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 buy and sell transactions in a specific batch, and ultimately forms a block with one batch. Therefore, it is able to fundamentally prevent MEV based on price differences, such as arbitrage, and minimize the LVR of LP 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 improve LP profitability. Hooks is one of the architectural upgrades of the upcoming Uniswap V4, which allows Uniswap’s liquidity pool contracts to be modularly customized according to various usage methods (dynamic rates, TWAMM, out of range, etc.).

Bunni V1 was originally a liquidity provider derivatives (LPD) protocol that, together with Gamma and Arrakis Finance, improved the limitations of centralized liquidity proposed by Uniswap V3. However, with the launch of V2, Bunni built its own DEX by combining various Hooks, including out of scope Hooks.

Pooled liquidity refers to a liquidity provision method that allows LPs to directly determine an arbitrary price range for LPing to improve the capital efficiency of liquidity provision positions. While this pooled liquidity improves capital efficiency, its limitation is that LPs must continuously adjust the range of liquidity provision to match changing market prices. Therefore, Bunni provides a solution that automatically manages the range of liquidity provision when LPs hold funds in custody.

Source: X (@bunni_xyz)

Out of Range Hooks is a new attempt to improve capital efficiency by interoperating idle liquidity with external protocols, rather than re-adjusting the liquidity provision range when idle liquidity exceeds the current market price range. By depositing idle liquidity in lending protocols and funding pools that can generate interest income (such as Aave, Yearn, Gearbox, Morpho, etc.), it not only provides LPs 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 risks due to liquidity interoperability or reduced liquidity required for AMM exchanges) will need to be closely observed, and these trade-offs may come 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 is difficult to find a convincing reason to use DEX. Even if the usage of DEX continues to rise, the 14% usage rate compared to CEX is, frankly speaking, 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 a native value proposition unique to DEX that cannot be experienced by CEX.

Source: AAVEnomics Update

In this regard, liquidity provision (LPing) and profit distribution 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 serve as a channel for CEX liquidity to flow into the chain, providing market participants with more motivation to contact DEX. At the same time, the profit distribution mechanism may become the starting point of a self-sustaining economic system or token economy, in which participants contribute and are rewarded according to token incentives in decentralized protocols, 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 features reviewed in this article are also intended to achieve this goal. CoW AMM captures MEV internally to eliminate LP risk, while Bunni V2s out-of-scope function maximizes LP profitability by interoperating liquidity within the AMM pool. Although not mentioned in this article, some DeFi protocols have recently explored attempts to internalize OEV (oracle extractable value) profits in oracle-based price data.

Furthermore, the importance of this is further highlighted as the mechanism by which protocols redistribute value gained from the protocol to protocol participants has been re-emphasized recently. In fact, Aave Protocol has proposed a new AAVEnomics plan to repurchase $AAVE through protocol revenue and distribute it to $AAVE holders. Meanwhile, Uniswap’s fee switch has also been recently reignited, and Aevo has also announced that it will repurchase AEVO.

As DeFi protocols attempt 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 distributes transaction fees to UNI holders through a proposal, then a portion of the transaction fees that were previously obtained entirely by LPs must be shared with UNI holders. In this case, in order to redistribute value to protocol participants, more value needs to be accumulated within the protocol than before, which also highlights the importance of internalizing the value previously extracted from external entities.

In this context, protocols like CoW AMM and Bunni V2, which we discussed today, are attempts worth paying close attention to by proposing differentiated liquidity provision methods or developing mechanisms to return the value obtained by the protocol to ecosystem participants. In addition to these, various protocols are also developing attempts to improve LPing, such as Osmosiss Protorev to prevent tailing transactions, or Smilee Finances impermanent return as a way to hedge the risk of impermanent loss. The process by which DeFi protocols create their unique value through these attempts cannot be provided through CEX or CeFi, and will continue to be an important observation point for the gradual increase in DEX activity in the future.