DeFi Needs Liquidity Providers, and Liquidity Providers Need Benchmarked DEX Returns

By Mark Lurie, CEO of Shipyard Software

Within the world of decentralized finance (DeFi), there are many different decentralized exchanges (DEXs). Instead of relying on a centralized authority to make markets, these DEXs rely on a mix of clever algorithms and crowdsourced liquidity to facilitate their peer-to-peer digital asset swaps. As a result, DEXs have greatly helped expand access to global pools of capital.

DEXs only work if they attract enough liquidity providers (LPs), the users responsible for providing the liquid assets used within these decentralized markets. As a result, there is a constant scramble for DEXs to outshine competing DEXs by advertising artificially inflated LP returns. 

This is not only misleading to LPs, it makes it harder for DeFi users and investors alike to identify which DeFi projects are truly sustainable and which ones are low quality dupes. The only way to determine which DeFi projects warrant attention, and which ones should be left to die, is to find a better way to benchmark actual, bottom-line LP returns across different DEXs.

Liquidity Providers Make DeFi Possible

Before we get in too deep, let’s clarify the relationship between DEXs and LPs. Each DEX is powered by an automated market maker (AMM), which is a type of decentralized protocol that uses mathematical formulas to price digital assets. While AMMs are powerful algorithms, they can’t make markets without liquid assets. These AMM-powered DEXs need LPs to provide crypto assets to a dedicated liquidity pool. Each liquidity pool is essentially a smart contract that is specifically designed to facilitate trades between the assets contained within that pool.

Typically LPs are incentivized to provide their capital to a liquidity pool in exchange for a cut of the trading fees earned by the DEX. Once in the pool, traders can freely swap between these two assets by either depositing or withdrawing from the pool, instead of interacting directly with one another.

DEXs Are Misleading Liquidity Providers

Different DEXs offer different LP returns, and LPs are always trying to find the best return on their capital across various pools. However, the vast majority of DEXs are deliberately misleading LPs by advertising top-line yield figures based on revenue, instead of providing a bottom-line figure after accounting for potential costs. This isn’t just limited to DEXs; the broader DeFi industry regularly misuses the term “APY”, which has historically been referred to profit, not revenue. And in this case, this sleight of hands makes it much harder for LPs to get a clear understanding of their true profit potential on any individual DEX, let alone compare actual bottom-line returns across different protocols.

But this is not just an issue of cherry-picking metrics. Most DEXs today rely on a specific type of AMM called a constant product market maker (CPMM), which introduces an LP cost called impermanent loss (IL) due to the way the protocol balances its liquidity pool assets. Every LP on a CPMM-based DEX risks having their gains eroded, or wiped away completely, by IL. However, CPMM-based DEXs like Uniswap continue to show revenue-based LP yields while failing to provide details on the losses their LPs incur. In fact, up to half of Uniswap’s LPs may actually be in the red despite the rosy revenue returns it advertises. And since Uniswap’s AMM design has been adopted by dozens of other DEXs, this issue is compounded across the DeFi space. As a result, users don’t realize the losses they’ve incurred until it’s too late.

Benchmarking Returns is the Only Way Forward

Nominal yield figures like the ones Uniswap uses are misleading, whether they’re used to evaluate the earning potential of a single liquidity pool or to compare multiple protocols. The fact that relative losses like IL vary significantly across different liquidity pools and DEXs highlights how difficult it is to standardize how returns are calculated and communicated — but it also underscores the need to do so. 

The first and most important step to accomplishing this is to define a set of standards against which all LP yield figures are compared based on bottom line profit. Within a TradFi context, this would be akin to how mutual fund managers’ success is evaluated by how much they beat a market benchmark such as the S&P 500 or Vanguard Total Stock Market Index. Applying this same approach to DeFi will make it much easier for LPs to incorporate complexities like impermanent loss into their analysis. In other words, LPs will be able to accurately compare different DEX returns by evaluating each opportunity against the same benchmark over a given period of time. This allows them to make better capital allocation decisions, which benefits their bottom line and well as the broader DeFi space. 

Without liquidity providers, the DeFi ecosystem would grind to a halt. The only way to ensure that LPs are supporting the most capital-efficient projects is to empower them with the right tools to compare actual returns across different DEXs and DeFi protocols. But the answer is not the creation of a grandiose cross-DEX tracking tool – it begins with individual DEXs taking it upon themselves to communicate more accurate, profit-based LP yields. After all, the only businesses that make it hard for users to compare relative benefits across other organizations are ones that win by keeping users in the dark. If a DEX claims to offer above-market LP returns, basing yield figures on profit is the only way to prove it.

About Mark Lurie:

Mark Lurie is the CEO & Co-Founder of Shipyard Software. He is a serial entrepreneur and investor who previously founded two venture-backed startups. Codex is a blockchain-based title registry for art & collectibles used in the offline auction world with 500,000 NFT titles created (ICO 2018). Prior to Codex, Mark founded an online marketplace for art & collectibles, which was acquired in 2016. Previously, Mark was an investor at Bessemer Venture Partners, where his investments included Twilio (TWLO). He is currently a Venture Partner at FJLabs and a board member of GMO Trust (issuer of GYEN, the first Yen-backed stablecoin) and the Foundation for Art & Blockchain (a 501c3 nonprofit). He has an MBA from Harvard Business School and a BA in Economics from Harvard College.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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