Bots steal $500 million from DeFi liquidity providers every year. CoW DAO’s new exchange stops them – DL News

• CoW Protocol introduces a new AMM to protect liquidity providers from MEV bots.
• The new AMM will force arbitrage bots to bid for the right to rebalance liquidity pools.
• CoW AMM will provide the greatest benefit to those providing liquidity to less popular investment pairs.

Liquidity providers are crucial to the $68 billion DeFi ecosystem. These DeFi users deposit their tokens in so-called liquidity pools to enable trading for a small fee.

But providing liquidity – or LPing – comes with risks. A temporary loss can occur when the balance of tokens in a pool changes and tokens become worthless to LPs. And then there are so-called MEV bots, which reduce profits and can even lead to long-term losses for liquidity providers.

CoW DAO, the developer cooperative behind the decentralized exchange CoW Swap, wants to make things easier for liquidity providers. It just launched a new so-called Automated Market Maker – or AMM – to combat MEV bots and hopefully save liquidity providers an estimated $500 million each year.

“There has been an active academic discussion on this topic for at least a year,” Alex Marsh, one of the lead authors of CoW DAO, told DL News. “We don’t know of any other teams working on this.”

Stay up to date with our weekly newsletters

AMMs – exchanges that use liquidity pools instead of market order books to facilitate trading – are currently the most popular way to trade tokens in DeFi. The leading decentralized exchange Uniswap uses an AMM model.

MEV bots: a double-edged sword

MEV stands for maximum extractable value. It refers to the potential value that can be generated by reordering transactions within blockchain blocks. Almost all MEVs are carried out by lightning-fast bots.

MEV bots provide a valuable service by smoothing out on-chain price differences and creating more efficient DeFi markets. However, many types of MEV are also harmful to traders and liquidity providers. Bots can push transactions to buy assets before another trade pushes the price higher.

Sandwich attacks – an advanced form of front running – are one of the most common types of MEV.

Join the community to get our latest stories and updates

Here, MEV bots scan the Ethereum network for users to buy a token, then jump in the queue and place a large order in front of them, driving up the price. After the victim's trade is settled and the price continues to rise, the bot sells the tokens at a new higher price.

A June report from investment firm Galaxy Digital estimated that MEV bots stole between $300 million and $900 million from traders on Ethereum using these strategies.

According to CoW DAO, the amount that liquidity providers lose to MEV bots specifically is greater than the loss lost to front-running and sandwich attacks combined.

Loss versus realignment

CoW DAO’s new AMM aims to protect liquidity providers from MEV bots by eliminating something called LVR – or loss-versus-rebalancing.

LVR refers to the losses incurred by LPs due to arbitrage MEV bots exploiting stale prices in liquidity pools. By rebalancing pools, bots make a small profit and make prices more competitive for traders – but at the expense of liquidity providers.

According to CoW DAO, liquidity providers for major token pairs are earning 5-7% less than they should due to LVR.

To address the discrepancy, CoW DAO’s new AMM will force arbitrage bots to bid for the right to rebalance liquidity pools. This ensures that arbitrageurs continue to have an incentive to rebalance pools, but also allows the protocol to return the majority of profits to liquidity providers.

“This is the most desirable model, but also the most difficult to implement because it relies on creating a competitive bidding market,” Marsh said. “Fortunately, the CoW protocol already has this.”

An academic paper published in November compared current AMM models with the bidding system used in CoW AMM. The results of six months of backtesting showed that CoW AMM's LP returns would have been equal to or higher than Uniswap's returns on 10 of the 11 most liquid non-stablecoin pairs.

According to Marsh, CoW AMM will provide the greatest benefit to those who provide liquidity to less popular asset pairs, more than those who do so to popular asset pairs such as stablecoins.

“Stable-to-stable liquidity pools provide fewer attack vectors for arbitrage bots and tend to earn more in fees than they lose in LVR,” he said.

Tough competition

CoW AMM is not the first product from CoW Protocol. In 2021, the collective launched CoW Swap, a product that enables peer-to-peer token exchanges and helps traders evade MEV bots.

While CoW Swap has gained a loyal following and facilitated over $34.8 billion in trading volume, it is still an order of magnitude away from Uniswap, the leading decentralized exchange with over $2 trillion worth of traded assets.

Although CoW AMM will be the first of its kind to be deployed, there is little to stop other exchanges from launching similar products in the future. Those with a larger share of the decentralized exchange market may be able to outperform CoW DAO despite its lead.

CoW DAO’s competitors may even already be working on their own solutions. “Given the scale of the problem, we wouldn’t be surprised to see other teams exploring other types of LVR solutions,” Marsh said.

Tim Craig is DL News' Edinburgh-based DeFi correspondent. Contact us with tips at [email protected].

Learn Crypto Trading, Yield Farms, Income strategies and more at CrytoAnswers
https://nov.link/cryptoanswers