DEX 1.0 and Rented Liquidity
DEX 1.0 and the double-edged sword of rented liquidity pools
For RadioShack to win in the current decentralized swap game (henceforth referred to as DEX 1.0), it must convince users & aggregators to use the RadioShack swap.
To win that, customer slippage must be extremely low.
Slippage is the price difference between the submitted transaction and the actual completed transaction on the blockchain. Swap users find high slippage to be anathema.
Two dynamics are responsible for slippage:
- 1.High Swap Volume
- 2.Low Liquidity
RadioShack has an elegant solution to minimize slippage.
The logical place to start is to own extremely deep liquidity pools.
In general, the deeper the liquidity pool, the lower the slippage. Therefore, users (and DEX aggregators) route swaps through the deepest liquidity pools to achieve the optimal outcome for their swap.
But there is a problem with the current DEX 1.0 solution. The current major players do NOT own their own liquidity - they rent it - meaning other users provide liquidity to the protocol in return for rewards (normally minted by the DEX in a yield farm).
This has multiple negative consequences/externalities:
A. As the DEX mints its tokens to continuously encourage users to provide liquidity, it dilutes itself (see the 1920's Weimar German republic). Yet despite incurring the damage of dilution from new tokens minted, the protocol still doesn’t own the liquidity. It’s just paying the users to park their liquidity in the pool while the rewards are flowing. The moment the rewards stop flowing, the users flee and so does that rented liquidity. A quick spiral to the bottom ensues.
B. Regardless of the reward rate, there’s always churn in ‘rented’ liquidity pools. Someone may remove their liquidity to deploy in another more lucrative opportunity, or might even panic sell in a downward market. For each person removing their liquidity from a pool, the DEX has to find someone else to replace that liquidity to achieve the same level of slippage. This constant churn is coined the ‘leaky bucket’ problem and defined as, "How a bucket with a constant leak will shrink if...the average rate at which water leaks out exceeds the rate at which the bucket is filled." For all current DEX 1.0 a steady-state point is reached where the churn eventually catches up with the speed of adding new liquidity as formulated below:
When the saturation condition is satisfied, the pool no longer grows - a cap on how deep the liquidity is reached (which annoyingly keeps the DEX from offering low slippage to its customers). This graph is the horrific destiny for all liquidity pools in all DEX 1.0's:
And even further than this graph above illustrated, the dynamics get even worse because the only way to achieve deeper liquidity (once saturation is reached), is to increase the reward rate to attract more liquidity providers. However, as more liquidity accumulates in the pool, the churn increases until Equation 1 is satisfied again, at which point the liquidity growth stalls yet again. This is similar to a drug addict who sadly needs more and more to get their fix.
And to complete the above death spiral, the swap fee dynamics now deteriorate because the larger the pool, the lower the fee per pool participant (same swap fee spread thinner among more pool participants).
Enter RadioShack Swap with the solution.