Liquidity Auction
This article was written in May 2021. However, due to various factors, the product mentioned was not put into development. The concept is now published for readers’ information.
Intro
Liquidity Auction is a new DeFi primitive. It is an extension of AMM and is expected to offer retail liquidity providers with a much higher yield return than existing AMM DEXes.
Specifically, it will be a product based on AMM(using some kind of CFMM curve for quote). It remains permissionless for liquidity providers, but the right to trade will be commoditized and sold in regular auctions. The highest bidders will have the exclusive right to trade against the liquidity pool for that period of time. LPs will no longer receive yield from swap fees but will earn the amount paid by the bidder, which is equivalent to “renting” the entire pool of liquidity with a sum of money.
The trend of on-chain liquidity
The current paradigm of on-chain liquidity is undoubtedly AMM, including decentralized exchanges such as Uniswap, Curve, and Balancer. The most important contribution of AMM is to provide retail investors with the opportunity to participate in providing liquidity. However, this is at the expense of flexibility, which also results in AMM’s market-making efficiency always being suboptimal.
Uniswap V1 was quite elementary when it was launched in 2018. Many subsequent AMMs aimed to improve Uniswap, such as specific CFMM (Curve), concentrated liquidity (Kyber DMM, Uniswap V3), and dynamic fee (Balancer, Curve V2), AMM still has a lot of room for improvement in performance. However, after the emergence of aggregators (1inch, Matcha, Tokenlon), we found that the proportion of professional market makers (RFQ) has picked up and we can feel that a new trend is happening quietly.
AMM: The dilemma between “agency problem” and “professional market-making”
Looking at financial markets outside the blockchain space, there are almost no open-end funds focusing on market making, due to retail investors having inherently difficult contradictions to participate in market making. Unlike general mutual funds, market making as a strategy is not quite interpretable. Its profitability has nothing to do with subjective market conditions. Managers are more likely to have conflicts of interest, so it is difficult to win the trust of retail investors. AMM in the DeFi world is exactly the answer to this question: when the market maker strategy is solidified and becomes a part of the investment contract, the agency problem is solved. When an investor puts money in, it means agreeing to this foreseeable profit and loss of the strategy.
It can be said that AMM and professional market makers are two diametrically opposed strategies. Professional market makers must possess the ability to predict market direction: the better the market maker’s forecasting ability, the more competitive the quotation will be and the higher the profit. On the other hand, Uniswap completely abandons the use of external information and only refers to its own reserves to generate quotations, thereby obtaining path independence and strong resistance to manipulation. Such fund utilization efficiency is of course imperfect and suboptimal, but it can ensure the predictability of the worst-case scenario and is the key to onboard retail investment to provide liquidity.
The problem of AMM externalities
Today’s AMM has the goal of competing with centralized exchanges for efficiency. Going back to three years ago, you may only remember that Hayden made the first version of Uniswap, but this was actually Vitalik’s idea, with the purpose of creating “publicly accessible liquidity”. This is of course an innovation, but the issue often lies on the other side of the equation. When the liquidity provided by investors is publicly accessible, it will naturally lead to common externality problems. In addition to the market maker and traders, there is also a third party called “arbitrageur”, which seizes value and causes a net loss in the system.
Here we can use two extreme examples to distinguish the situation of arbitrageurs who help maintain liquidity and those who are simply harmful. Suppose there are some LPs in an ETH-USD pool:
(1) The external price of ETH/USD is constant, and some normal transactions come in, causing the price to deviate, and the arbitrageur will do a reverse transaction to pull back the price.
(2) The price of ETH/USD has changed significantly, and there is no “real” trader during the period. Only arbitrageurs enter the market to push the price in the pool to reflect the external price change.
Arbitrageurs in scenario 1 create value for LP and make profits (LP benefits from arbitrageurs); arbitrageurs in scenario 2 only bring net losses to LP (LP would rather there are no arbitrageurs). In practice, the result is usually a mixture of the two scenarios, but it is not difficult to see that the AMM model of “deciding how to react to the outside according to its own state” is too passive, and it is almost inevitable to be arbitrage, which results in the well-known issue, impermanent loss.
Compared with simply holding the same portfolio, the ebb and flow of fee income and IL is an eternal issue for LP. Assuming that there is a Uniswap with zero swap fees, providing liquidity will result in a guaranteed loss due to the introduction of IL. Conversely, if there is a benevolent actor who is always willing to adjust the position for Uniswap at the market price, then the LP will make a steady profit. The trouble with AMM is exactly this, because it couples “Quote Strategy: xy=k” and “Profit Strategy: 0.3%” together, which leads to Uniswap asserting the following discrete terms for liquidity providers: “Due to IL being an unavoidable paradigm in AMM systems, there will be unavoidable losses taken due to arbitrageurs. However, transaction fees taken will at least account for some losses being recovered in this model.”
Game analysis of liquidity auction
Market making using AMM that involves retail investors cannot be as airtight as professional market makers, suffering IL as an unavoidable consequence. To combat inefficiencies in the current AMM model, we propose a new solution: liquidity auctions. The concept of liquidity auctions was inspired by the MEV auction. The occurrence of arbitrage cannot be eliminated, however, the value of liquidity can be determined above board with value discovery being determined through public auctions. By privatizing the right to access liquidity, the risk of obtaining potential profit or loss for a period of time can be purchased and undertaken by a single individual for a period of time to achieve a more out-and-out capture of the potential value of the liquidity pool.
We expect that most of the participants in the auctions will be professional market makers, because these parties possess deep knowledge of utilizing liquidity. However, the LP income under the liquidity auctions is not necessarily higher than the ordinary AMM. With pricing determined by auction, there are logical reasons as to why LP’s income would be higher than that of AMM.
The first reason why an auction model is attractive is the issue of IL. With IL the issue is potentially more serious with zero swap fees, but at least the value will be redistributed between the buyer and the seller. Under game theory, this is enough to ensure that the highest price will continue to approach all the profit that professional market makers expect to make despite the risk of IL.
Second, the privatized AMM eliminates the problem of mempool competition. Without potential race conditions, market makers can better quote and arrange transactions to maximize profits. Because of the exclusive access during the period, market makers can adjust positions on a larger time scale, reducing the friction of frequent position rebalances.
Third, remove swap fee, that is, the spread from the strategy parameter, so that professional market makers who are aware of the market can dynamically adjust and be more flexible, and will naturally get higher than the fixed swap fee AMM Traffic and total revenue are reflected in the bidding price.
Finally, even in extreme situations where the above reasons are not valid, the winning bidder can apply the liquidity into the same quotation and cost strategy as Uniswap at any time. There should be a relationship of “greater than or equal to” between the amount of the liquidity auction and Uniswap’s revenue during the same period.
Conclusion
From a relatively high-level, abstract perspective, AMM can actually be regarded as a series of pending orders, and the pending orders themselves are valuable for market making teams with quantitative trading capabilities. This is why many quant trading firms like to build exchanges, especially zero-fee exchanges, because they can always squeeze money out of retail orders. The liquidity auction is like these zero-fee exchanges, and with more fairness.
The system can be thought of as analogous to wool markets: a group of sheep is reared in Spring and we auction the opportunity for outsiders to shave their wool. The actor on the market who has the opportunity to shave the highest quality wool will naturally be the one who is willing to pay the highest price. LP token acts as a fence, and AMM curve xy=k acts as shearing scissors, the payment is the pasture for the sheep, and all of this ultimately provides the benefit for the sheep who wish to have their winter coats shaven.
