GM, this is your Daily Bolt briefing.
In this edition, we’ll be updating you on the current state of privacy protocols in crypto including mixers like Tornado Cash, private L1s, and dApps. As the US government maintains its firm stance on crypto regulation, it’s more important than ever to stay up to date on this kind of info…
Afterwards; read our Note of the Day to learn more about how you can maximize capital efficiency in DeFi, whether you are a trader, avid liquidity provider, or just someone looking to save on DEX swap fees.
One last thing: yesterday we released our Project Breakdown on Raft, a decentralized lending protocol for stETH; you can access this report for free, as we’ve made it available for all Revelo Intel members!
Sign up for a Revelo account today and access this exclusive reports like our Raft Project Breakdown and Timeline, at no cost to you. More on this tomorrow…
Stay alert, stay informed.⬇️
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aiPX offers cutting-edge risk management for liquidity providers, leverage trading, and a suite of products between perpetuals, binary options, and synthetics.
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1/ The Delphi Podcast - Decrypting Privacy with Penumbra
Preview: In the episode of The Delphi Podcast which took place on May 2, 2023, Tommy Shaughnessy, Can Gurel, and Henry de Valence discusses privacy infrastructures, including L1s, L2s, dApps, and smart contracts like Tornado Cash. They also explore Penumbra's two-phase protocol for privacy, and more. Click here to listen to the full episode (93 mins).
Read our Note (18 mins) and save 75 mins.
Here are some key takeaways:
Penumbra Labs - Penumbra (Not live yet, the team expects to launch the mainnet in 2023) is a fully private proof-of-stake network and decentralized exchange for the Cosmos ecosystem.
Henry explains that Penumbra is building a private DEX as the start of an interchain privacy layer. The goal is to create private apps that outperform transparent alternatives, with trading as a prime example. By controlling information disclosure, they can outcompete other options. Penumbra aims to make privacy tech mainstream, but they need to plan the necessary steps. They want to gradually achieve a privacy-focused brand vision with competitive products.
Tommy asks Henry about the grand vision of his private DEX, and Henry explains that their main focus is to create general-purpose privacy technology that can act as an interchain privacy layer. They want to make interactions between smart contracts and applications public, semi-private, or fully private.
Tommy brings up the issue of regulation and its impact on privacy in the crypto community. He mentions the sanctions imposed on Tornado Cash and asks Henry where he stands on addressing regulation while maintaining privacy as a human right.
Henry argues that designing for compliance disclosure is necessary for operational competence in using a system. He gives an example of how a web wallet for a private chain needs to disclose individual transaction contents to an untrusted page, but only for technical security reasons.
Henry believes that trying to design protocols as a response to regulation by enforcement is a mistake. In a world where there are no clear rules, adding more disclosure tools to a protocol will not solve the problem of regulation by enforcement. There is a fundamental problem with the rule of law when regulators do not establish clear ground rules from the start.
Henry believes that there is a lot of uncertainty regarding the actions regulators may take, but the development of privacy-preserving software and encryption technology is well-established in the United States, and they are not worried about that part.
What's On My Mind - Capital Efficiency in DeFi
In this episode of What’s On My Mind, which took place on May 5, Nick Drakon and Souvlaki discuss the capital efficiency in DeFi, swap fee APRs, choosing the right DEXs from the perspective of traders and LPs, zero-fee in DEXs and sandwich attacks. Read our notes below to learn more.
Background
Nick Drakon (Host) - Founder of Revelo Intel, Host at DeFi Sparks podcast, and full-time investor.
Souvlaki (Host) - Researcher at Revelo Intel, Co-Host of DeFi Sparks podcast.
What is Capital Efficiency?
Souvlaki explains that capital efficiency measures how efficiently capital is being used on a protocol.
He says that capital efficiency is calculated by taking the total trading volume and dividing it by available liquidity or total value locked (TVL).
According to him, high capital efficiency means that less TVL is required to generate higher volumes.
Souvlaki warns that capital efficiency numbers can be manipulated by undercutting swap fees in the market.
He states that having lower fees than others can make a DEX more capital efficient but may not result in higher returns for liquidity providers.
Nick says that when evaluating a DEX from a business perspective, capital efficiency alone does not tell much. Users need to consider its fee-generating potential as well. He says that a DEX, which is more capital efficient, might bring less revenue for liquidity providers (LP).
The Importance of Capital Efficiency and Swap Fee APR
Souvlaki explains that LPs care more about swap fee APR than capital efficiency.
According to him, capital efficiency measures how well capital is being used, while swap fee APR measures the return per dollar of capital deployed and provides a better measure of capital profitability.
Souvlaki believes that capital efficiency is an indicator of liquidity depth and can be used to find the best pricing. For this reason, he believes that traders should look at capital efficiency to take advantage of the best pricing.
He believes that no single metric should be looked at in isolation; it should always be considered in conjunction with others to get a full picture of the business. Users should decide what they want and employ these metrics in accordance with that.
Nick agrees and mentions that different stakeholders have different priorities, so it's important to frame these numbers depending on the perspective of the stakeholder.
Examples on Uniswap
Souvlaki explains that on ETH/ARB pool with a fee of 0.3% on Uniswap has a TVL of $21.4 million, generating a volume of $1.7 million and fees of $5,000 over a 24-hour period, resulting in capital efficiency of almost 8% and a swap APR of 8.7% (data collected on May 2nd), which he finds low and this shows that low capital efficiency can lead to low swap fee APR rewards.
Nick says that this pool has a high fee percentage, low capital efficiency, and low swap APR to its LPs.
Souvlaki explains that on ETH/ARB pool with a fee of 0.05% has a TVL of $30.3 million, generating a volume of $23.33 million over a 24-hour period, resulting in a capital efficiency of almost 80% and a swap fee APR of 14% (data collected on May 2nd).
Souvlaki mentions that dropping fees has greatly increased capital efficiency, but this didn’t affect the swap fee APR as much as it affected capital efficiency.
He thinks that pools with low fees should be more capital efficient if it wants to attract LPs who are looking from the perspective of fee generation.
Nick explains that the examples are not meant to claim that one setup is better than another but LPs and traders should evaluate from their perspective.
Reason for Two Pools For ETH/ARB
Souvlaki explains that two pools exist on Uniswap for the same ETH/ARB pair to maximize returns in different market environments for LPs.
According to him, in normal trading environments, lower fee pools always outperform higher ones in terms of fee generation because traders use the pool with lower fees.
Nick states that in high-volatility environments, high-fee pools perform better than low-fee pools because traders care less about swap fees and more about taking advantage of opportunities in the market.
The Behavior of Bots During High-Volatility Periods
Nick believes that during periods of high volatility, users pay higher fees, which then leads to higher bot activity, trying to take advantage of arbitrage opportunities.
Challenges with Uniswap Pools
Souvlaki believes that the challenge with Uniswap pools is to manage your position actively from one pool to another. If it is a low-activity pool, LPs may be losing APR.
He says that the pool with a 0.3% percentage of the fee has high TVL because it performs well during periods of volatility. He states that LP providers should consider whether they anticipate frequent market volatility before selecting a pool.
Examples of Trader Joe
Souvlaki says that the ETH/ARB pool on Trader Joe with 0.2% fees has a TVL of $4.3 million, generating a volume of $692,663 over a 24-hour period, resulting in a capital efficiency of almost 16% and a swap fee APR of 11.7% with a reward APR of 13.2% (data collected on May 2nd).
He states that Trader Joe pool performs better than both pools on Uniswap.
Trader Joe is the only example that gives additional farm rewards. With the additional farm rewards, LPing at Trader Joe will net 25% in returns which is significantly higher than the two Uniswap pools in the above examples.
Selecting a Pool
Nick says that when selecting which pool to provide liquidity, LPs should consider TVL, volume over the last 24 hours, capital efficiency, fee structure (fixed or dynamic), swap fee APR and any additional rewards provided.
He believes that considering these numbers through the lens of what environment (volatile or non-volatile) they were generated in and what externalities affect them will determine their profit.
Dynamic Fees
Nick says that DEXs aim to optimize their fee structure so that they can generate the most favorable returns for LP providers and convince them to stay in the protocol.
Souvlaki explains that dynamic fee is the ability of the protocol to change the swap fees of the liquidity pool based on market conditions.
According to him, high volatility in the market can lead to increased swap fees, while low volatility can lead to decreased swap fees.
He believes that lowering fees in a low-volatility environment attracts more volume, increasing the swap APR. He also says that raising fees during high volatility yields higher returns for liquidity providers.
UniSwap's Two-Pool System
Souvlaki explains that Uniswap has two pools for the same ETH/ARB pair because they are unable to dynamically adjust fees at a contract level.
He states that other DEXs like Balancer and Beethoven Finance use dynamic fee pools successfully.
He reiterates that despite its limitations, Uniswap remains relevant due to user loyalty and trust in its longevity.
User Loyalty vs. Trust
Souvlaki explains that large wallets with VC funding remain loyal to Uniswap due to its longevity and reputation.
According to him, Pancakeswap on Binance Smart Chain (BSC) also has a loyal user base despite being a Uniswap V2 fork.
Nick believes that trust in protocols plays a larger role than loyalty.
Souvlaki thinks that using aggregators instead of being loyal to one project is necessary for the market to find balance.
Capital Efficiency and Profitability in DeFi
Souvlaki states that protocols often promote capital efficiency without considering profitability for LP providers.
According to him, this can lead to LPs being attracted to deposit into protocols based on capital efficiency metrics that may not be beneficial for them.
Nick says that Revelo Intel’s upcoming products and services around financial reporting and analysis aim to address this issue.
Zero Swap Fees in DEXs
Nick believes that there is a possibility that swap fees for DEXs will trend toward zero, similar to what happened with brokerage fees in traditional finance.
Nick asks Souvlaki why a zero-fee environment is unlikely to occur in DeFi.
Souvlaki says that a zero-fee environment could make it more conducive to sandwich attacks where bots front-run trades and extract value from traders.
He explains that DODO started off as a DEX aggregator with zero swap fees on their pools, but they eventually introduced swap fees to prevent sandwich attacks.
Souvlaki says that sandwich attacks are still happening even after DODO lifted their swap fee off zero, indicating that lifting it may not have been enough to mitigate the issue completely.
Market Orders and Sandwich Attacks
Nick explains that a sandwich attack is a form of front-running that primarily targets decentralized finance protocols and services.
He says that market order is what most orders are on decentralized exchanges.
Nick argues that market-makers on Robinhood have the ability to front-run trades by leveraging their knowledge of user preferences, much like bots can front-run trades in zero-fee environments through sandwich attacks.
Nick explains that this process, commonly referred to as a sandwich attack, involves bots stepping in just before a transaction is finalized to buy and slightly increase the price, causing users to pay a slightly higher price compared to what they would have paid otherwise. This value extraction occurs on platforms like Robinhood and other brokers that sell user order flow.
Nick says that having zero swap fees makes it difficult to get good pricing execution.
He believes that having a fee ensures that bots incur costs and have to make decisions about whether their moves are profitable. If users set their slippage tolerance to 10, 20, 30, 40, or 50 basis points, they can mitigate the effect of a sandwich attack.
He concludes that a zero-fee environment is potentially quite unlikely in the status quo because of sandwich attacks.
Important Links
Show Information
Medium: Podcast (Youtube)
Show: What's On My Mind
Show Title: Trade Using Metrics and Analysis: Capital Efficiency in DeFi
Show Date: May 5, 2023
aiPX is the official sponsor of the Daily Bolt by Revelo Intel
In a post-FTX world, securely trading with leverage and earning real yield in a decentralized manner has never been more important.
aiPX offers cutting-edge risk management for liquidity providers, leverage trading, and a suite of products between perpetuals, binary options, and synthetics.
Earn passive yield and trade with leverage straight from your wallet.
Take the step, join aiPX.