Cost of Fee Switch

activating the protocol fee comes at a cost

Alex @lajarre | 🧈 Butter

EBS 2023-11-07

🧈

Agenda

1. 🦄 Uniswap model
2. 🧛🏼 Attack
3. 💰 Funding mechanism
4. 🤯 Teachings

🧈

🦄 Uniswap model

🧈

Uniswap v2 fork competition game

Model:

• 2 competing AMMs
• A ↔ B pools
• Swappers allocation:
  cost ≃ price impact
• LPs allocation:
  revenue ≃ volume

🧈

Swappers allocation

Price impact:

🧈

See Angeris et al: "An analysis of Uniswap markets", 2019

Swappers allocation

Utility:

🧈

🧈 allocate more towards AMM with larger reserves

Swappers allocation

🧈

🧈 marginal allocation
towards AMM
with larger volume

LPs allocation

🧈

Equilibrium under network effects

🧈

🧛🏼 Attack

fork + subsidy = liquidity flight

🧈

Simple model:

• fee switched on forever

Fee switch

🧈

Intuition:

• If fee switched on, then no-fee competitor captures more than its fair share.
• Use this extra volume to fund a subsidy.
• With enough subsidy, network effects move equilibrium towards competitor.

Allocation game

🧈

🧈 at equilibrium, subsidy makes LP allocation indifferent

🧈 equilibrium +ε counteracts network effects: liquidity flight

Subsidy

🧈

⚠️ reallocation will be lower because of switching costs
(brand, smart contract risk, legal…)

V = 10^8 USD
R = 10^7 USD
R_1(0) = 100%

Total cost

🧈

💰 Funding mechanism

🧈

Intuition:

• AMM 2 has no fee switch in its governance surface
• raise debt rather than equity to fund the subsidy
• funding via governance mechanism or crowdfunding

Funding mechanism

🧈

Subsidy funding

🧈

🧈 avoid equity-like funding: capture via wealth condensation

🧈 if governance surface:

Debt(GovernanceFutureRevenue)

➡️ parameter auctions
➡️ proposal auctions
➡️ auctions & futarchy

🧈 crowdfunding: LPs and swappers will fund if more efficient (coasean argument)

Source of funds

see https://ethresear.ch/t/governance-mixing-auctions-and-futarchy/10772

🧈

🧈

what does this prove about governance?

🤯 Teachings

🧈

🧈 XV is the present value extracted by UNI tokenholders out of the protocol

🧈 XV is limited by the attack:

• either ρ > 0 is fixed: volume will be reduced ultimately to 0
• either ρ is modulated to limit liquidity flight

Upper limit on eXtractible Value

🧈

🧈 forking & smart contracts influence governance

🧈 grim trigger on UNI tokenholders

Internalize externalities

🧈

👋 🧈

twitter.com/butterymoney

twitter.com/lajarre

https://bit.ly/3QvNsQj

🧈