Research Pulse #76 08/01/2022

  1. Towards a Theory of Maximal Extractable Value I: Constant Function Market Makers
    Authors: Kshitij Kulkarni, Theo Diamandis, and Tarun Chitra

Maximal Extractable Value (MEV) represents excess value captured by miners (or validators) from users in a cryptocurrency network. This excess value often comes from reordering users transactions to maximize fees or inserting new transactions that allow a miner to front-run users’ transactions. The most common type of MEV involves what is known as a sandwich attack against a user trading on a popular class of automated market makers known as CFMMs. In this first paper of a series on MEV, we analyze game theoretic properties of MEV in CFMMs that we call reordering and routing MEV. In the case of reordering, we show conditions when the maximum price impact caused by the reordering of sandwich attacks in a sequence of trades relative to the average price impact is O(log n) in the number of user trades. In the case of routing, we present examples where the existence of MEV both degrades and counterintuitively improves the quality of routing. We construct an analogue of the price of anarchy for this setting and demonstrate that if the impact of a sandwich attack is localized in a suitable sense, then the price of anarchy is constant. Combined, our results provide improvements that both MEV searchers and CFMM designers can utilize for estimating costs and profits of MEV.

Link to Paper (People.EECS)

  • MEV once stood for Miner Extractable Value but the advent of new value extraction strategies has broadened its scope beyond mining.
  • This paper formulates the notion of Maximal Extractable Value mathematically to include not only transaction ordering but also block reorg attacks akin to those presented in Flashboys 2.0, the seminal MEV paper.
  • In addition to interesting mathematical models depicting MEV, this paper also features important design insights for MEV extractors and CFMM implementers alike.
  1. Token Incentives and Platform Competition: A Tale of Two Swaps
    Authors: Xiaofeng Liu, Wei Chen, and Kevin Zhu

Platforms compete intensively to attract users. Monetary subsidies are commonly used to incentivize users’ adoption but such subsidies are expensive. In this paper, we study impacts of token incentives, an alternative incentive approach, in the competition of two decentralized exchange platforms. Decentralized exchanges enable the exchange between a pair of crypto tokens through a liquidity pool, among many liquidity pools on a decentralized exchange platform. The platform depends on liquidity providers to supply liquidity that facilitates transactions from the demand side, which makes the amount of liquidity supply the key to platform success. In our context, the entrant platform, Sushiswap, launched token incentives to attract liquidity providers from the incumbent, Uniswap, who then also retaliated with its own token incentives. Our empirical analysis of the two platforms shows that Uniswap’s own token incentives attract more liquidity to the platform. Surprisingly, we find that the token incentives from the competitor, Sushiswap, also bring more liquidity to the incumbent. Regarding potential mechanisms, we find that increased liquidity of Uniswap mainly comes from the increased number of liquidity providers. The token incentives from the competitor Sushiswap may have brought more new liquidity providers to Uniswap. Meanwhile, the incentives from Sushiswap may also impose a competition effect that decreases the amount of liquidity per provider on Uniswap, as existing providers shift liquidity to Sushiswap to harvest the rewards from both platforms. The analysis of heterogeneous effects reveals that high-volatile pools benefit less from the competitor’s token incentives relative to more-stable pools. Our results provide important insights and practical guidelines on the design of token incentives in platform competition.

Link to Paper (Questrom World)

  • Crypto mechanism design is still in its very early stages. As such, there are events that challenge key assumptions of how an application’s incentive structures can be rid of attacks.
  • This paper evaluates one such event: the creation of Sushiswap and its impact on the activity and incentive structure within Uniswap.
  • The authors derive key insights from the Liquidity Pools within each platform during the highly competitive period following the launch of Sushiswap where several large Liquidity Providers operated in both protocols.
  1. Daric: A Storage Efficient Payment Channel With Penalization Mechanism
    Author: Arash Mirzaei

Lightning Network (LN), the most widely deployed payment channel for Bitcoin, requires channel parties to generate and store distinct revocation keys for all n payments of a channel to resolve fraudulent channel closures. To reduce the required storage in a payment channel, eltoo introduces a new signature type for Bitcoin to enable payment versioning. This allows a channel party to revoke all stale payments by using a payment with a higher version number, reducing the complexity of storage from O(n) to O(1). However, eltoo lacks a penalization mechanism, which may incentivise profit-driven channel parties to close a payment channel with a stale payment state, to their own advantage. This paper introduces Daric, a payment channel for Bitcoin that simultaneously disincentivize profit-driven attackers and achieves optimal storage. In addition, to achieve higher efficiency and robustness, Daric does not rely on any particular properties of the underlying digital signature to prevent state duplication.

Link to Paper (IEEE Xplore)

  • There has been an increased number of publications focused on alternative Payment Channel Networks (PCNs) that attempt to iterate upon Bitcoin’s Lightning Network.
  • This paper presents Daric, an alternative PCN construct intended to minimize existing attack vectors in Lightning and improve the efficiency of Peer-to-Peer payments via a new signature type.
  1. Cycle: Sustainable Off-Chain Payment Channel Network with Asynchronous Rebalancing
    Authors: Zicong Hong, Song Guo, Rui Zhang, Peng Li, Yufen Zhan, and Wuhui Chen

Payment channel network (PCN) is a promising off-chain technology for blockchain scalability, but it suffers from poor sustainability in practice. In other words, due to the imbalanced transfer in channels, the balance in one direction of channels gradually becomes exhausted until the PCN is rebalanced via a consensus-based rebalancing protocol, during which the involved channels must be suspended. This paper presents Cycle, the first off-chain protocol for a sustainable PCN. It not only keeps the PCN at a balanced level consistently but also avoids the channel freeze incurred by the rebalancing protocol, leading to minimum failed payments and sustained PCN service, respectively. Cycle achieves these benefits based on a novel idea of asynchronous rebalancing. During the normal off-chain running, the participants share the information about their payments and asynchronously rebalance the PCN following the principle that payments along circular channels can cancel each other out. To guarantee security, the protocol resolves the disputes resulting from network latency or malicious participants by a message mechanism for synchronization and a smart contract for arbitration. Moreover, to address the privacy concern during the information sharing, a truncated Laplace mechanism is designed to achieve differential privacy. Finally, we provide a proof-of-concept implementation in Ethereum, over which a real data-based simulation shows that Cycle satisfies 31% more payments than the state-of-the-art technique.

Link to Paper (IEEE Xplore)

  • Once depleted, payment channels must to be rebalanced in order for their owners to continue transacting. This involves several operations that can be performed either on-chain, with channel top-ups/refills, or off-chain, with technologies like Submarine Swaps.
  • Nevertheless, there is still no consensus on what is an appropriate mechanism to improve both the efficiency and usability of payment channels via rebalancing.
  • This paper introduces Cycle, which is an alternative PCN implementation that experiments with some of these trade-offs.
  • Interestingly, the Proof-of-Concept presented was implemented on Ethereum and the authors share promising benchmarking data on its theoretical performance.
  1. Analysis of Liquidity Provision within Uniswap V2
    Authors: Alexei Condurachi and Nicolai Musing Tudborg

This project comprises of an introduction to Decentralized Finance, its infrastructure, and Decentralized Exchanges, as well as an analysis of the various aspects that impact gains for liquidity providers of the largest Constant Product Market Makers: Uniswap-V2. A digital twin of the CPMM has been built in order to undertake simulations and analysis. Data collected directly from Uniswap has been used to set the initial parameters of simulations to recreate trading trends that are currently occurring in the market.
Experiments are conducted varying the number of liquidity providers interacting, their initial holdings and tokens tradable. Moreover, the impact of different trading fees on liquidity providers’ returns has been investigated. Results show that providing strategically liquidity to pools proves to be a profitable strategy that yields positive annual returns up to 1%. Experiments indicate also that the presence of other active providers influences returns to different extents and in different way. Smaller liquidity providers are seen to benefit from the presence of wealthier providers, while bigger liquidity providers are negatively impacted by active providers with similar portfolios. As expected, gains are directly correlated to pools’ trading volumes, as they are the source of profit for liquidity providers. This can be seen by the strategies adopted by providers.

Link to Paper (GitHub)

  • There is a debate in the industry related to the economics of provisioning liquidity to Constant Product Market Makers (CPMM), such as Uniswap V2.
  • Due to impermanent loss, a type of liquidity shortage caused by arbitrageurs, liquidity providers are at times better off just holding the underlying asset instead of actively providing liquidity to these pools, as shown by previous work.
  • This paper revisits this question and shows that, in Uniswap V2, providing liquidity strategically can result in a return of 1%. This is an interesting insight given that previous work estimated this rate to be negative.

Excellent selection of papers. There’s a very clear throughline of mechanism design here. I’m fascinated by the opportunity, or perhaps necessity, for organizational designers to learn from game theoretical attacks. Next-gen decentralized organizations will need to learn a new vocabulary.