In DEX trading, every tokenized penny counts. But all too often, flaws in the system chip away at potential profits, according to Paradigm’s Dan Robinson.
Decentralized trading ecosystems often “leak” value that would otherwise be captured by swappers and liquidity providers, Robinson says.
The general partner and head of research at Paradigm describes the three main ways that value flows out of DEXs at the expense of participants.
On the Bell Curve podcast (Spotify/Apple), Robinson explains that the top priority of a DEX should be “growing the size of the pie” for both swappers and liquidity providers. “If DEXs are successful, both are going to be very well served.”
One major way that value leaks out of the system is termed “loss-versus-rebalancing,” Robinson says.
When a user provides liquidity on a DEX and the price changes elsewhere, such as on a centralized exchange, traders can arbitrage the difference. Robinson explains, “liquidity providers lose money compared to what they would have […] if they had just executed at the new price — or if they didn’t trade at all.”
“The average cost of that trade is worse than the current price that they could be getting for the asset, so they’ve lost a little money within this block compared to the cost of rebalancing,” he explains.
Another major way that value leaves the system is caused by price slippage, where traders execute an order at a price that is worse than what they might have been able to get elsewhere. The most egregious form of such price slippage happens when a trade undergoes a sandwich attack, Robinson explains.
“They see your trade coming on an [automated market maker],” he says, “and they trade ahead of you to cause you to get a worse price.”
“So they frontrun you first and then they backrun you. They trade the other direction on the AMM in order to lock in a profit for themselves.”
It’s a tactic that can result in “pretty much risk-free profit” for the attacker, Robinson says. “That’s one that again, I think people were talking about since the early days of Uniswap, but sort of got professionalized over the course of the years.”
“It’s a big problem and one that’s important to address,” he says.
Gas fees are the third means of value leakage that Robinson describes, which is paid “in the form of the base fee or the EIP-1559 burn.” Users pay a significant cost, he says, just to use the Ethereum platform. “Improvements in that have typically come from trying to gas-optimize the implementation and make it as efficient as possible.”
Robinson sums up the three areas as different forms of MEV, or maximum extractable value, that are ultimately stripped away from DEX participants.
Importantly, some of the potential value never enters the system in the first place, Robinson says. Gas fees can be so high that traders are dissuaded from participating at all. “You see on [layer-2s], we start to see volume actually goes up a lot once you decrease the fixed costs of trading.”
“Similarly with liquidity provision, you might get a lot more liquidity provided if you didn’t have loss-versus-rebalancing. And you might get a lot more volume if it couldn’t be sandwiched or if you wouldn’t have slippage.”
“This is not value that’s going to swappers or LPs [liquidity providers]. It’s not even value that’s going to MEV. It’s just stuff that isn’t actually happening,” he says. “It’s deadweight loss.”
“Reducing that deadweight loss by decreasing some of these costs, I think, could benefit everyone in the system.”
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Source: https://blockworks.co/news/paradigm-dex-liquidity-value-leaks