Assessing Liquidity Pool Fee Recommendation through a Benchmark Market Fee

Objective

Background

Overarching requirements

  1. The test should encompass all relevant dimensions at stake in the optimization recommendations, i.e. (i) swapping fees/SF (ii) trading liquidity/TL (iii) arbitrage volume/AV (iv) market prices/P (v) transaction costs/TC (vi) slippage/S
  2. The test should be sensitive to the relationship between TL and SF with AV, i.e. a change in TL or SF parameters is expected to be reflected in AV
  3. The test metric variation (first order derivative) should be normalized with regard to market risk, i.e. the metric of quantification is not sensitive to positive or negative effects coming from market prices.
  4. The test should have as little model risk as possible, therefore a benchmark approach where the latter is theoretically robust and practically legible is recommended.

Approach for designing a benchmark

  • We can infer the conditions of maintaining a sustainable pool for a particular asset by looking at the trading activity on the open market
  • It amounts to estimating the required liquidity and the asset volatility on the open market
  • That volatility provides a measure of the “cost of risk” that the protocol is facing to access the required liquidity
  • Applying this cost of risk to the volume necessary to cover the price imbalance provides a “fair” value of the trading fee to apply to arbitrageurs: fee that breaks even the protocol’s cost and arbitrageurs’ cost
  • Doing so, we can assess the capacity of Almanak fee to adapt to the market cost of liquidity.

Conceptual Workflow

Conceptual Workflow of a Benchmark Market fee (ex. for Bancor one-sided pools)

AMM Math Framework and Test Rationale

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Web3 research firm oriented on decentralized protocols and their economic security.

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Almanak

Web3 research firm oriented on decentralized protocols and their economic security.