The Cost of Price Discovery
On the profitability of Liquidity Providers on the Uniswap AMM
I made a Dune dashboard on that has caused a stir among prominent members in the Decentralized Finance (DeFi) community. It's disturbingly revealed those who think they have invented perpetual motion.
A story about a chart, a cookie, hubris, social proofing, and the future of DeFi.
The Chart
Last month, I did an analysis on order flow toxicity around the Uniswap V3 ETH/USDC pools. Uniswap V3 LPs on ETH/USDC have lost an estimated $100 Million Dollars after fees on top of their original liquidity provider (LP) holdings (link)
LPs in AMMs profit when the fees > Impermanent Loss and lose money when the fees < Impermanent Loss.
Impermanent loss is the DeFi term for the adverse selection that occurs when providing liquidity passively. The chart says that LP fees < IL this year by ~$100M.
How does the chart measure profit? It measures the "markout" of every trade for ETH/USDC pools on Uni V3. The markout is the unrealized PnL of a trade using a price in the future. For example the 5m markout = the unrealized PnL 5 minutes after the trade occurs.
This is a commonly used measure in tradfi for hft market makers, where I previously worked. It measures the execution quality across many time horizons. Markouts estimate our realized PnL because finding exact entry and exit of every LP and trade is tedious.
Here's how to interpret this chart :
LP unrealized PnL after 5 mins: -$21M
LP unrealized PnL after 1 hour: -$56M
LP unrealized PnL after 1 day: -$97M
LP unrealized PnL after 7 days: -$92M
@0xShitTrader interpreted this chart to suggest that retail should not participate in passive liquidity providing on CPAMMs due large losses. I am personally neutral to that view, though I understand where it coming from. LPs in ETH/USDC are down bad YTD.
THE COOKIE
@teo_leibowitz, @xin__wan, and @AustinAdams10 of Uniswap's Venture and Research arms sent a scathing thread saying that my analysis "took the cookie "on chart crime vs @Uniswap”, claiming that it was wrong in every dimension.
Uniswap's team claimed that I was not counting fees in my analysis, and that Uniswap's ETH/USDC pool was actually profitable by $150M since inception.
A truly mind boggling difference. Their query (link)
@0xShitTrader discovered that Uniswap had a bug in their query that was throwing out all LP buys, over HALF of all of the LP trades.
When correcting for the bug, their analysis looked identical to the original chart, showing almost $100M in losses to LPs marked to 1 day.
This was brought up to their team immediately. It has been over 5 days since and they have not retracted their statements, compelling me to write this thread to prevent misinformation.
I don't mean to wax poetic in the next few tweets, but the fact that the Uniswap team thinks it was reasonable that $150M in profit was made providing passive liquidity in the ETH/USDC pool is simply astounding to me.
HFT desks with insanely fast connectivity infrastructure with armies of PhD quants competing in a market 50x the size of crypto would be happy to make half as much of that profit. How could a passive liquidity provider with no information even come close?
The confirmation bias of the Uniswap team is clear They believe that the realities of financial markets simply don't apply to them They truly think that they have invented perpetual motion, a post-history money printing machine with no alpha generation required.
The truth is simply that capital is over-allocated to providing liquidity in the ETH/USDC pools. This is not a knock on AMMs or the Uniswap team. That is just the reality of the current state of the world.
I'm not pointing this out to play negative sum status games or to beat my chest and shill my own protocol. DeFi is in an existential crisis and we as a community need to be intellectually honest to ourselves about what we've accomplished.
AMMs are an amazing tool for stable swaps and for bootstrapping liquidity on long-tail assets Rivaling CeFi technology and execution quality for highly liquid symbols is something we as a community are still trying to solve. It may not ever be possible.
There is too much capital on-chain looking for yield. This results in almost every opportunity yielding in negative risk premiums, Uniswap pools non-withstanding.
There is over $70B+ of stablecoins sitting on ETH. There are not enough productive use cases for this capital, especially in an environment where risk free rates are over 4%.
Switching costs for liquidity is high. Most of the capital hasn't woken up to the stark reality. We are sitting on a blessing of capital that most of the DeFi community is taking for granted.
DeFi is racing against time trying to convince this capital to stay. Innovation, creativity, and real productive use cases are necessary for the ecosystem to survive. We cannot rest on our laurels because DeFi is nowhere near a sustainable end state.
We as a community need to abandon the promises of financial alchemy and perpetual motion machines of the last cycle and focus on long term sustainable sources of innovation that DeFi can actually solve.
I hope this can be a wakeup call to the builders of the space. Many of us have been incredibly lucky to amass capital and build through the bear market.
Let's make sure we're aiming at the right target because we owe it to society to make it a better place.