LP rewards - What's the minimum required - latest research

I was looking through the latest literature on these topics and thought it might be worth getting feedback on because this is an important issue as we grow Pangolin.

The ever-marvellous Tarun Chitra, Guillermo Angeris and Alex Evans published a short paper last year discussing this very topic so I’m surprised it hasn’t received more attention. Or maybe it has but just not much in public. There are some important insights from this paper that are very relevant to us as we grow Pangolin and I’ve seen a lot of debate about how to incentivise pools that seems random and emotional when what it really needs is better analysis and expert advice.

I hope I can generate some interest in looking more closely at the implications offered by this research.

The paper can be found here: https://arxiv.org/pdf/2012.08040.pdf

The plain language version can be found here: Can you hear the shape of a CFMM? (part 3) | by Tarun Chitra | Gauntlet | Medium

The question the researchers posed themselves was very simple: what is the lower bound required to guarantee that the portfolio value of an LP, after arbitrage and subsidy, is nonnegative? And a corollary to that, what would be required to entice LPs from other platforms to a competing platform?

Well, these 3 brilliant minds have come up with an elegant formula to set that out. First, they start with some assumptions:

A. They define the initial price of the external and secondary markets as image and image

B. They assume the external market is κ-liquid if it satisfies, for ∆≥0, f(∆)−f(0) ≥ κ∆.

C. They assume that the price impact functiong for some market is μ-stable whenever a (nonnegative) trade of size ∆ does not change the market’s price by more than μ∆.

D. As before, they assume that the secondary market, with continuous, non-decreasing price impact functiong, is μ-stable with the definition given above.

E. They define image

From this, they show that there is a simple expression for the amount of subsidy (R - in our case, PNG) that is sufficient to compensate an LP in the traded asset is: image

I think that’s an incredibly elegant result.

In particular, they note that more subsidy has to be provided when:

(i) h becomes small (i.e., the token is subject to price changes with large drift) or
(ii) when μ/κ is large (i.e. the secondary market, for which the LPs are providing liquidity for, is very illiquid compared to the external market).

As I understand this, it means that how much subsidy we need to provide to LPs depends not just on the drift of the asset over time (such as that seen on tokens with low liquidity and new tokens), but also the relative curvature of the two markets - something that is generally negligible on established stablecoin pairs and more severe on stablecoin <=> non-stablecoin pairs.

The other important insight from this paper is how LPs can hedge for impermanent loss by selling a basket of put options on the traded assets as the LP leaves the pool. It’s a bit hard to do anything with this until we see an established derivatives market develop so I won’t dig into that much further here other than to note that derivatives are an important tool and should be given priority if we want Pangolin to become a market leader.

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It’s probably all good on an academic level but the big problem with this type of analysis is that they do not include opportunity costs: can a liquidity provider get more returns elsewhere? If the answer is yes, than the pools will empty.

The important difference is that we will all better understand the mechanism required to reward LPs across those pools that the Pangolin community wants to support. And secondly, as an LP myself, having a better understanding of break-even points and hedging strategies is really important.

The research has another important consequence - it provide a mechanism to estimate what sort of incentives would be needed to entice LPs from other pools to Pangolin. That’s important to know in the current extremely competitive environment where airdrops and other incentives are the main weapon.

The best way to find out is to simply ask them (the big LPs on the non-PNG pairs). My guess is most will remove their liquidity if rewards drop 10x.

Hedging strategies are purely theoretical for now. Even BTC options are still too illiquid and have way too many swings in implied volatility to be useful for precise hedging strategies.

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Sure - but that is a race to the bottom that will quickly play out over the next few months. We’re in a ponzi phase as LPs rush to high APRs, buy the underlying token and dump into the next wave of LPs. Eventually, the waves of new capital subside and we’re left with a very different dynamic. I think we need to understand what that future dynamic looks like.

Guillermo and Tarun were interviewed recently and noted that the concave nature of AMMs meant that most investment strategies lead to a optimum point relatively easily without the need for fancy maths or elaborate strategies so the simplest short-term strategy is to ape into pools with high APR. It’s a very low barrier to entry for smaller LPs looking for return on capital, especially for Pangolin given the low transaction costs.

What does that mean in practice? It means that the underlying reward token will always get devalued sooner or later as LPs parasite off the host, extract value and move on. It also means that you can’t hold onto LPs unless you bolt them down into multi-year escrows. You would think that has no attraction to LPs but it does if we get the underlying mechanics right. If you lurk around the Yearn and Curve forums, they are having very different conversations right now and many of them involve considering where they want their platforms to be in 5 years.

If the community is not prepared to take that step (i.e. incentivise very long-term engagement in priority over short term, fruitless, support of the PNG price), then we will quickly find ourselves fighting an impossible mission to maintain artificially high APRs as our only tool.

The problem is that everyone is vampiring liquidity from everyone else - it’s now rapidly heading towards a zero-sum game. I’m getting alerts 3 times a day for new AMMs opening up shop with the same tactic.

That’s my main beef with a lot of the so-called “strategies” to hold onto big LPs and sustain PNG prices. It’s not the sort of competitive edge we need to sustain Pangolin and not where the smart money is going. They’re already at the next step.

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New dexes will keep popping up forever, not just over the next few months, because there is no reason why they shouldn’t and the cost and necessary skill to start a new dex is low.
But, I don’t think whales will just put millions in any new dex, chasing those early gains. None of the other new dexes like Yeti or Panda got any large traction, simply because it is way to risky to dump millions in a dex with anonymous developers and potentially shady contracts.
However, I do think non-PNG LPs can be chased away from Pangolin by changing the reward schedule so that is it becomes only marginally profitable. They will just leave and never come back. And without non-PNG LPs there is no dex, just a group PNG stakers who are swapping PNG with each other in order to get more PNG. And that is just silly.

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Totally agree - and the behaviour of the pools over the last few weeks seems to bear that out. Perhaps Pangolin can start with several core pools to build things up but without incentivising pools that reflect the top 20-30 coins by trading volume (including things such as LTC, DOGE, XRP etc), Pangolin will remain a niche DEX.

If we have a look at what Flare is doing with their upcoming launch, they’ve already approached the XRP, DOGE and LTC communities and got rapturous support to include those tokens onto the Flare platform. DOGE and XRP holders will receive an airdrop. Flare is going to have their native token, Spark, listed on every major exchange from day 1.

The reason for that approach? Flare realised that there are already billions (and soon trillions) of dollars of liquidity trapped in tokens lacking native smart contract functionality. That liquidity can’t move around easily like that associated with ERC-20 tokens. The thing is that Flare won’t be live for another few months so there is still a window of opportunity there for anyone smart enough to grab it. What’s more striking is that Flare is built on Avalanche+EVM.

Why aren’t we exploring and mining those rich seams of liquidity too? It’s first mover advantage in this game.