Recently, we took a tasty dive into what liquidity really means and why it’s absolutely crucial in defi for sustainable growth. It forms the bedrock of successful trades and fluid volume.
In a similar vein, it’s important to consider the mechanics of how our trades and markets are actually executed on a DEX, and by extension aggregators. We hear about market makers (MM) and automated market makers (AMM) from traditional market news as well as crypto analysts, so let’s parse out the details in order to confidently navigate defi moving forward.
If liquidity is the oil that represents the availability of a coin or token to buy or sell, then MM/AMM are the engines of defi themselves.
On a centralized exchange, a market maker is an entity that provides liquidity for trades so that the CEX can execute buys and sells at desired prices as quickly and precisely as possible. The CEX acts as the middle party here while various companies or monied private traders create orders mirroring those of users to ensure that trading pairs retain proper backing, selling into your buys and buying into your sells.
If this weren’t the case, slippage could easily occur wherein buys or sells would fill at higher or lower prices than desired due to low liquidity for trading, which often means someone receives less than desired for their trade.
This phenomenon of a buy or sell substantially increasing or decreasing the measured market cap of a project beyond expected levels due to available liquidity is called price impact. Projects with poor liquidity can experience extreme volatility in price when larger holdings are bought or sold; we’ll look at this idea closer shortly.
On a decentralized exchange, there are no intermediaries like with a CEX; the goal is to match buyers and sellers directly. Instead, an automated market maker, comprised of automized smart contracts, dictates asset price and liquidity. What we know as liquidity pools are essentially just smart contracts tasked with holding various amounts of an asset provided by any number of wallets, and the AMM draws upon these liquidity sources to execute trades.
Unlike on a CEX where market making is reserved for deep pockets, anyone can provide to an LP pool on a DEX as long as they meet the conditions set forth in the AMM smart contracts. As we’ve already observed, many liquidity pools reward providers with percentages of fees via LP tokens in exchange for their liquidity, which incentivizes further LP. Some protocols even allow those LP tokens to be staked, a process called yield farming, which affords liquidity providers additional reward incentives.
While this approach is greatly decentralized and fairer for the average investor to take part in LP, a DEX is also more likely to run into the aforementioned issues of slippage and price impact when liquidity is thin. This is most common with new or small asset pairs where volatility can be higher; as we covered previously, GOLD1 solved this issue by converting 1% of all token volume directly into LP tokens and burning them, ensuring healthy and sustainable liquidity over time.
Impermanent loss is another potential concern in AMM wherein asset prices shift excessively within a liquidity pool and the value of one’s LP token changes compared to when someone provided liquidity.
It’s called impermanent because the loss is only realized if one removes liquidity. The possibility of the asset ratio reverting back is always there, and LP token rewards alongside yield farming can sometimes offset these temporary fluxes. For long-term LP in sustainable projects, the risk from IL is typically the lowest.
Now that we’ve laid out the plans for how defi markets work, we can zoom in on some details to uncover interesting potential for generating value for our Gold Mine in the future.
MEV originally stood for ‘miner extractable value’ in a proof of work context wherein miners would organize blocks of transactions in such a way as to maximize the fees they extract; this was possible because miners controlled which blocks were included or excluded, and how they were ordered. On Ethereum, which is now proof of stake, validators assume these functions, so MEV stands for ‘maximal extractable value’ in this case.
We most often hear about MEV in the context of MEV bots, and they are indeed a very common way people glean value from pending transactions. They can help to stabilize prices across various DEX and defi overall, but they in some cases they can also negatively impact traders via front-running or spiking gas fees.
Arbitrage entails looking for price differences across various DEX in order to buy an asset at a lower price in one place and then sell it at a higher price in another within one transaction. This can be done manually or automated via a bot and is highly competitive due to its popularity and simplicity.
Sandwich trading entails watching DEX mempools (essentially a waiting room for transactions before they’re approved) and identifying a large trade, and then quickly buying just before it and selling right after it to capture the price impact as MEV. This is likely how many of us usually hear about MEV bots, having seen a buy front-run and then immediately sold on by a bot.
There are other types of MEV, but these two are generally the most well-known and encountered so it’s helpful to understand their mechanics.
In the context of GOLD1’s ecosystem, sandwich trading bots benefit trading volume and help to feed the Gold Mine via taxes, but it can’t be forgotten that this experience is typically pretty negative for traders. While this type of bot isn’t ideal, they aren’t going away for the time being so having them feed the Mine and contribute to rewards for stakers is an improvement.
Arbitrage bots would provide a more compelling addition to our ecosystem. These bots could constantly scan DEX for price discrepancies, execute arbitrage trades, and feed the profits right into the Gold Mine. Regardless of the number of bots, this would help to maintain price parity across defi as all arbitrage trades inherently do while also rewarding GOLD1 stakers.
These MEV opportunities can reward validators and stakers for securing transactions, but when validating blocks is generally not as profitable as mining them was, this could encourage the centralization of validators, which isn’t healthy for Ethereum’s decentralization overall. Additional details surrounding some ideas we’ve looked into in this work can be found here, but for the purpose of thinking big for GOLD1 we’re going to consider two particularly fascinating solutions to centralized MEV incentives: Proposer-Builder Separation (PBS) and Builder API.
Ethereum consensus currently employs validators to include, exclude, and order transactions to be included on blocks to be attested to by other validators, which permanently adds those blocks to the main beacon chain.
PBS would separate the block-building and block-proposing functions from validators into a new block builder entity. Builders would create a bundle of transactions and then bid to be included in the chain by a validator. Validators check all builder bids and choose the one with the highest bid; auctioning blocks in this manner would strongly discourage dishonest bundles because builder bids are paid regardless of their inclusion in the chain or not.
Once a validator accepts the highest bid, they create a signed proposal for the block to be minted and send it to the builder to be published. Just as with our current validator-only system, other validators would also need to attest to this block before the builder could complete its publication. If too many validators declared a block invalid, it would be discarded and the builder’s bid would still be collected by validators.
Under this PBS system, validators still enjoy income from high builder bids, but they are no longer pressured to spin up MEV extraction by growing larger and more efficient at scale, which would reduce the overall number of validators due to being unable to compete with large ones. Instead, MEV will be captured by builders, and additional smaller validators and stakers can participate in validating blocks and accepting builder bids. This would be a great boon to keeping Ethereum decentralized and trust-heavy.
PBS would require Ethereum’s consensus protocol to change, so while full implementation may take more time, we can also consider Builder API in the interim.
This strategy incorporates many PBS ideas into the current validator-only system by having networks of builders submit blocks and bids to validators to be accepted and proposed for minting, in a sense forming an agreement to follow a back-and-forth blind verification of a block before accepting it. Just like in PBS, bids and fees are always paid by builders, and trying to double sign blocks would result in slashing for validators, so it’s financially disincentivized to attempt block censorship.
Now, imagine our Golden DAO investing in creating Ethereum validator and builder nodes under PBS or Builder API. We could take part in securing transactions, netting MEV through our builder node(s), and benefiting from other builders’ bids with our validator node(s). All of this value would automatically feed into our Gold Mine, which would reward stakers and allow us to assemble additional nodes for extra passive rewards should the DAO so choose.
In addition to that, we could partner with or acquire projects whose aim it is to optimize or develop MEV extraction for builders and enable solo or small stakers/validators on Ethereum to aid in decentralizing the network. The Merge has brought with it new frontiers to explore, which means our Golden DAO has even more opportunities to lead.