Research Pulse #95 12/12/2022

  1. NFT Wash Trading in the Ethereum Blockchain
    Authors: Massimo La Morgia, Alessandro Mei, Alberto Maria Mongardini, and Eugenio Nerio Nemmi

Non-Fungible Token (NFT) marketplaces on the Ethereum blockchain saw an astonishing growth in 2021. The trend does not seem to stop, with a monthly trading volume of $6 billion in January 2022. However, questions have arisen about such a high trading volume. The primary concern is wash trading, a market manipulation in which a single entity trades an NFT multiple times to increase the volume artificially. This paper describes several methodologies for identifying wash trading in Ethereum, from its inception to January 2022, and explores the tangible impact on NFTs. We found that the collections affected by wash trading are 5.66% of all the collections, with a total artificial volume of $3,406,110,774. We study two different ways of profiting from wash trading: Increasing the price of NFTs by showing artificial interest on the asset, and exploiting the reward token system of some marketplaces. We show that the latter is safer for wash traders since it guarantees a higher expected profit. Our findings indicate that wash trading is a frequent event in the blockchain eco-system, that reward token systems can stimulate market manipulations, and that marketplaces can introduce countermeasures by using the methodologies described in this paper.

Link to Paper

  • Wash trading is a type of market manipulation in which an individual simultaneously buys and sells the same asset in order to create the appearance of higher trading volume and liquidity. This can be done for a variety of reasons, such as to inflate the price of a cryptoasset.

  • Many have hypothesized that the growth of obscure NFT markets in 2021 and 2022 was due, in part, to entities involved with those projects engaging in wash trading.

  • This paper tests this hypothesis using both on-chain and off-chain data. Astoundingly, they find that 5.66% of all NFT collections have been impacted by wash trading with a total artificial volume of $3,406,110,774.

  1. Garrison: A Novel Watchtower Scheme for Bitcoin
    Authors: Arash Mirzaei, Amin Sakzad, Jiangshan Yu, and Ron Steinfeld

In this paper, we propose Garrison, which is a payment channel with watchtower for Bitcoin. For this scheme, the storage requirements of both channel parties and their watchtower would be O(log(N)) with N being the number of channel updates. Furthermore, using properties of the adaptor signature, Garrison avoids state duplication. It means both parties store the same version of transactions for each state and hence the number of off-chain transactions does not exponentially increase with the number of applications built on top of each other in the channel. Moreover, the new proposal avoids punish-per-output pattern, meaning that all outputs of a revoked state can be claimed using a single revocation transaction. Garrison can be implemented without any update in Bitcoin script.

Link to Paper

  • The Lightning Network has the potential to solve one of Bitcoin’s biggest challenges: the scalability and practicality of payments. However, there are still security issues that have prevented its adoption, such as the requirement for participants to be online to secure their channels.

  • In order to solve this impractical requirement, the concept of so-called “Watchtowers” was invented. “Watchtowers” are monitoring systems that circumvent the impractical requirement for participants to be online by socializing the monitoring of payment channels.

  • This paper introduces a new schema for the creation of Watchtowers called Garrison. Unlike many previous constructs, Garrison does not require changes to Bitcoin’s code and offers several efficiency benefits.

  1. Automated Market Makers: Mean-Variance Analysis of LPs Payoffs and Design of Pricing Functions
    Authors: Philippe Bergault, Louis Bertucci, David Bouba, and Olivier Guéant

We analyze the performance of Liquidity Providers (LPs) providing liquidity to different types of Automated Market Makers (AMMs). This analysis is carried out using a mean / standard deviation viewpoint à la Markowitz, though based on the PnL of LPs compared to that of agents holding coins outside of AMMs. We show that LPs tend to perform poorly in a wide variety of CFMMs under realistic market conditions. We then explore an alternative AMM design in which an oracle feeds the current market exchange rate to the AMM which then quotes a bid/ask spread. This allows us to define an efficient frontier for the performance of LPs in an idealized world with perfect information and to show that the smart use of oracles greatly improves LPs’ risk / return profile, even in the case of a lagged oracle.

Link to Paper

  • One of the biggest research areas in the industry in 2022 was the dynamics of liquidity provision to Decentralized Exchanges, such as Uniswap, given that not much is known about the users engaging in market making.

  • Much of the research in this area analyzes a phenomenon called Impermanent Loss (IL), which can drastically impact the returns of Liquidity Providers (LPs). Previous papers have found that LPs often underperform simple buy-and-hold strategies.

  • This paper corroborates this hypothesis and shows that, even when accounting for transaction fees, LPs perform poorly relative to the efficient frontier and very often face negative PnL.

  1. An Auditable Confidentiality Protocol for Blockchain Transactions
    Authors: Aoxuan Li, Gabriele D’Angelo, Jacky Tang, Frank Fang, and Baron Gong

Blockchain exposes all users’ transaction data to the public, including account balances, asset holdings, trading history, etc. Such data exposure leads to potential security and personal privacy risks that restrict blockchain from broader adoption. Although some existing projects focus on single-chain confidential payment, no existing cross-chain system supports private transactions yet, which is incompatible with privacy regulations such as GDPR. Also, current confidential payment systems require users to pay high extra fees. However, a private and anonymous protocol encrypting all transaction data raises concerns about malicious and illegal activities since the protocol is difficult to audit. We need to balance privacy and auditability in blockchain.
We propose an auditable and affordable protocol for cross-chain and single-chain transactions. This protocol leverages zero-knowledge proofs to encrypt transactions and perform validation without disclosing sensitive users’ data. To meet regulations, each auditor from an auditing committee will have an encrypted secret share of the transaction data. Auditors may view the private transaction data only if a majority of the committee agrees to decrypt the data. We employ a ZK-rollup scheme by processing multiple transactions in batches, which reduces private transaction costs to 90% lower compared with solutions without ZK-rollup. We implemented the proposed scheme using Zokrates and Solidity and evaluated the protocol on the Ethereum test network, and the total one-to-one private transactions cost only 5 seconds. We also proved the security of the protocol utilizing the standard real/ideal world paradigm.

Link to Paper

  • Privacy is important for the long-term viability of cryptoassets since it allows for greater economic freedom and autonomy, as individuals are able to make financial decisions without fear of surveillance or interference.

  • At the same time, privacy is hard to achieve in public blockchains because all transactions are recorded on a public ledger and associated with a unique cryptographic address that can potentially be traced back to a real-world identity.

  • This paper introduces an interesting privacy-protection mechanism for blockchains that uses Zokrates, an SDK for zkSNARKs on Ethereum, as well as Solidity to build a privacy-oriented zkRollup.