Grant Proposal <--> Surplus-capturing AMM study

CoW Grants Program Funded Grants
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1

Grant title

Surplus-capturing AMMs — a feasibility study

Authors: @mohammed , @0xEvan, Andrew

About the team

Andrew : Ph.D. Mathematics, 10+ years experience academic research at internationally leading pure research institutions. MEV research w/ Flashbots. awmacpherson.com

Evan: Mathematician, Data Analyst, DeFi Mechanism Design researcher. Previous research includes bonding curve controller modeling, analysis of RMM-01 LP mechanics, analysis of MEV arbitrage mechanics on POL, and cross margin risk modeling. evandekim.eth

Mohammed: Electrical/Electronics Engineer. MSc Economics focus on Asset pricing and credit cycle modeling. 5+ years in TradFi derivatives trading. Currently researching and building digital asset focused algorithmic trading/market making algorithms, PBS research and post-merge ETH testnet development (Ephemery/Holesovice).

Grant category

Analytics and Integrations

Grant description

Background

The proposal builds on a thread in the COW forum about a CoW-specific form of MEV-capturing AMM. The discussion surfaced exciting prospects for AMM designs that promise to take back control of “surplus” value ordinarily captured by arbitrageurs and MEV searchers. This value can then be deployed, for example, to achieve better prices for users and an improved overall return profile for LPs than the traditional CFMM.

The surplus distribution problem

In the classic CFMM design, prices are updated by arbitrageurs who are paid for this service by capturing the price differential between the CFMM and external markets. Liquidity providers (LPs) effectively bear these costs of this by constantly having to accept trades at unfavourable prices, a phenomenon known to economists as adverse selection. Although these costs can be offset by trading fees, this approach to value allocation is limited in two ways:

  • Linear trading fees equally impact arbitrageurs and “noise traders” who may be prepared to trade at prices favourable to LPs.
  • Arbitrageurs compete only for positioning of their transactions in the block, and the proceeds of this competition goes to block producers rather than LPs. There is no room for a competitive market for updating prices.

The CoW batch auction provides a more flexible approach to delivering price information which distinguishes arbitrageurs (or “solvers”) from noise traders and permits new dimensions of competition on price discovery. On the other hand, the CoW protocol as it stands does not provide its own liquidity, and in practice most of the liquidity comes from standard CFMMs whos LPs suffer adverse selection by trading with the CoW solver.

The basic idea of this proposal is to evaluate the feasibility and impact of an approach to AMM design which custodies its own liquidity but uses the pricing discovered by CoW solvers. Such an AMM would be quite remarkable in that it would provide a way to earn yield for LPs from passive liquidity provision without exposure to adverse selection at the some time offer better pricing for CoW users. Given the power of this result, it is natural to expect that some challenges lie in its realisation.

In our view, a feasibility study is necessary because of apparent confusion about the nature of the value that could be captured by such an AMM, undefined aspects of its design, and the security implications of using the CoW solution as a price oracle for an external protoocol.

References

Grant goals and impact

  • Propose high-level candidate architectures for “surplus-capturing” AMMs. In particular, address whether changes to CoW protocol itself are needed. Investigate security considerations, economic and otherwise, of the proposed architectures and discuss mitigation strategies.

  • Develop a quantitative model of the additional value that could be captured and delivered to LPs and users and measure it through empirical studies and simulations.

Deliverable A technical report outlining relevant theoretical background, design considerations, metrics, and results of empirical studies. GitHub repository containing the code used for data studies.

Impact The study will provide evidence as to whether current COW tools such as the competitive solver pricing can be utilized to build a surplus-capturing AMM in practise. It will also analyze the kind of “surplus” it would capture, its size, and the extra value users and LPs expect to receive. Thus preparing the ground for detailed design implementation.

Milestones

  • Architecture. Specify candidate architectures (which will be used to define simulations and economic attacks). Discuss:

    • How prices are communicated from solver to AMM.

    • How LP portfolios are managed.

    • Block/batch synchronisation.

  • Security. Study attack scenarios and propose mitigation strategies. Discuss fallbacks in case of a delayed or missing oracle update.

  • Quantitative. Compare portfolio metrics of LPs in proposed designs with those of a traditional CFMM using historical market data. Clarify the relation of these quantities to LVR.

  • Quantitative. Evaluate the use of COW solvers as an oracle for an arbitrage-free price by comparing the performance of COW solvers with other approaches to computing this price.

Grant timeline

6–8 weeks

Budget breakdown

Labor costs: 21K USDC (upfront)

Completion bonus: 180K COW (6 month vested for longer term incentive alignment)

Gnosis chain Address

To be disclosed to grants team

Terms & Conditions

By applying for this grant, I agree to be bound by the CowDAO Participation Agreement and the COWDAO Grant Terms and Conditions.

Thanks a lot for reading and reviewing.

2 Likes
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A report of this nature could be useful to help inform future iterations of CoW Swap, therefore I support this proposal in principal.

However, the budget breakdown and completion bonus will require modification.

I suggest that the 21k USDC payment for the report is made in two payments, one being upfront, and the other half upon completion and acceptance, reducing counterparty risk.

The Completion Bonus of 180K COW also seems abnormally high for 6-8 weeks of work, as a payment of that much COW has historically required a DEX to supply ~100M in volume to CoW Swap.

I will be interested to hear the views of the other grants committee members regarding this proposal.

2 Likes
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I also support this proposal in principal. While I think the quantitative results will be most useful, I like that it will also sketch out a concrete design for implementation

While of course it’s nice to point out which changes should be made in a v2 of CoW Protocol to better accommodate this use case, I would really want to receive if at all possible a concrete analysis & proposal on how this can be implemented on the current contracts (even with limitations).
In my view this is the only way to have real impact in the next 12 months (it’s unlikely we will develop new smart contracts before then).

1 Like
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Thanks a lot @netrunner.eth and @fleupold for feedback.

For the budget breakdown we have taken into consideration the feedback on splitting the payment and have also reduced the COW token compensation. I have updated the proposal here to reflect it which will also be reflected in the snapshot proposal.

It is indeed the mission to adopt a practical approach to the study which will allow for implementation immediately with current contracts. However, in our initial design discussions we realized some quick outcomes can be brought forward with some theoretic changes to the cow mechanism, so we felt it might be valuable to not shy away from exploring especially if there is a clear value win from doing so. The design focus however shall remain on the immediate implementation.

1 Like