In DEX trading, every tokenized cent counts. Too often, mistakes in the system create 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 value flows out of DEXs at the expense of participants.
On the Bell Curve podcast (Spotify/Apple), Robinson explains that a DEX’s top priority should be to “make the pie bigger” for both swappers and liquidity providers. “If DEXs are successful, both will be very well served.”
One major way value leaks out of the system is called “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 are losing money compared to what they would have […] if they had just executed at the new price – or if they did not trade at all.
“The average cost of that transaction is higher than the current price they could get for the asset, so they have lost some money within this block compared to the cost of rebalancing,” he explains.
Another major way value leaves the system is caused by price drops, where traders execute an order at a price that is worse than what they could have gotten elsewhere. The most egregious form of such a price drop occurs when a trade undergoes a sandwich attack, Robinson explains.
“They see your transaction coming on a [automated market maker],” he says, “and they trade before you so you get a worse price.”
‘So they first walk ahead of you and then behind you. They trade the other way on the AMM to secure profits for themselves.”
It’s a tactic that can result in “virtually risk-free profit” for the attacker, Robinson says. “That’s another one that I think people have been talking about since the early days of Uniswap, but has professionalized a little bit over the years.”
“It’s a big problem and it’s important to address it,” he says.
Gas fees are the third way of leaking value that Robinson describes, which are paid “in the form of the base fee or the EIP-1559 burn.” Users pay significant fees, he says, just to use the Ethereum platform. “Improvements in this regard have generally resulted from attempts to optimize the implementation and make it as efficient as possible.”
Robinson summarizes the three areas as different forms of MEV, or maximum extractable value, that are ultimately taken away from DEX participants.
Importantly, some of the potential value never makes it into the system in the first place, Robinson says. Gas prices can be so high that traders are deterred from participating at all. “You see further [layer-2s]we’re starting to see volume actually increase a lot if you reduce fixed trading costs.”
“Similar to providing liquidity, you could get a lot more liquidity if you didn’t have loss versus rebalancing. And you could get a lot more volume if it couldn’t be pinched or if there was no slippage.”
“This is not value going to swappers or LPs [liquidity providers]. It’s not even the value going to MEV. It’s just things that don’t really happen,” he says. “It’s deadweight loss.”
“Reducing that deadweight loss by reducing some of these costs, I think, could benefit everyone in the system.”