The problem

Examining the problem that presents our opportunity (to Monetize value that is traditionally lost in AMM order flow)

Preface - Our Origin Story

Our Origin story takes place after realizing the persistent problems in the liquidity landscape from our own experiences, we saw the need for a robust solution. Driven by our frustration in experiencing first hand the challenges of capital inefficiency and negative nuances in liquidity provision we embarked on our journey to seek a solution to the DeFi liquidity problem. During our research phase, our team came across a research report titled "A tale of two arbitrages". It conceived the notion that Impermanent Loss & Toxic Order Flow could be monazite under the right conditions. Diving deeper, our eyes were opened to the size of the opportunity that was presented before us, a potential to monopolize a potential billion dollar market vertical by simply privatizing the order flow within the volatility market. With this a plan was conceived to develop a groundbreaking liquidity solution under the umbrella of Private Pools Network. What resulted was an intense 12 month research & development process resulting in the worlds first, autonomous, fully decentralised, non-custodial, on- chain market maker.

Research Report Summary: Problems with Public Order Flow

Introduction

This report examines the challenges associated with public order flow in decentralized finance (DeFi), focusing on how it negatively impacts regular liquidity providers (LPs) and leads to substantial wastage of extracted yield. The discussion is divided into two primary issues: the adverse effects on LPs and the inefficiencies arising from the public nature of order flow, particularly the problem of Priority Gas Auctions (PGAs).

Impact on Liquidity Providers (LPs) - The three pillars of a perfect storm

Toxic Order Flow

Toxic order flow refers to the scenario where informed traders (informed searchers) execute trades based on information not available to the general market, such as external signals or private order flow data. This results in significant disadvantages for regular LPs, who are often unaware of the impending trades that will adversely affect their positions.

Mechanism: Informed traders use their superior information to conduct trades that capitalize on future price movements. For instance, if an informed trader knows that a large buy order is about to be executed on a centralized exchange, they can preemptively buy the same asset on a decentralized exchange, leading to a price increase that disadvantages existing LPs.

Impact on LPs: LPs provide liquidity based on current market conditions and available information. Toxic order flow disrupts these conditions, causing unexpected price shifts and losses for LPs. This erodes the profitability of liquidity provision, making it less attractive for regular participants.

Impermanent Loss

Impermanent loss occurs when the price of assets within a liquidity pool changes relative to each other, leading to a loss for the LP compared to simply holding the assets.

Mechanism: When informed traders exploit arbitrage opportunities, they cause significant price movements within the pool. LPs incur losses as the prices realign to the broader market, particularly if they withdraw their liquidity during these price changes.

Impact on LPs: Regular LPs suffer from these price fluctuations, which are often induced by informed traders' activities. The result is a lower return on their investment, further disincentivizing liquidity provision.

Volatility

Volatility in the market exacerbates the negative impacts of toxic order flow and impermanent loss.

Mechanism: High volatility leads to more frequent and larger price swings. Informed traders thrive in such environments, extracting more value through arbitrage and other strategies.

Impact on LPs: Regular LPs face increased risk and potential losses due to the unpredictable nature of volatile markets. Their liquidity positions become more susceptible to adverse movements, diminishing the overall appeal of providing liquidity.

Suboptimal Process of Arbitrage and Wastage of Extracted Yield

Public Nature of Order Flow and PGAs

The public nature of order flow in DeFi creates a competitive environment where multiple participants vie to execute profitable trades first. This leads to Priority Gas Auctions (PGAs), where traders bid up gas prices to ensure their transactions are prioritized.

Mechanism: In a PGA, traders engage in a bidding war, driving up the transaction fees to get their orders included in the next block. This is common in arbitrage opportunities where being the first to execute the trade is crucial.

Impact on Value Extraction: A significant portion of the potential value extracted through arbitrage is lost to these bidding wars. Estimates suggest that up to 80% of the value is wasted in PGAs, as it is transferred to validators and block builders rather than the traders themselves.

Validator and Block Builder Dominance

Due to PGAs, validators and block builders receive the lion's share of the value extracted from volatility and arbitrage opportunities.

Mechanism: Validators prioritize transactions based on the gas fees offered. As traders increase their bids to secure execution, validators collect higher fees, diverting a substantial portion of the arbitrage profits to themselves.

Impact on Yield: The excessive gas fees paid during PGAs result in diminished net profits for arbitrage traders. This inefficiency means that the overall system is less effective at capturing and distributing value, with a large part of the yield being absorbed by transaction costs rather than benefiting the broader DeFi ecosystem.

Example of the Problem Statement

The image above denotes a perfect depiction of both problem statements highlighted in our research summary above. Between May 2023 - May 2024 prominent block builder "Beaver Build" played part in extracting $150,000,000 worth of value extracted from volatility.

Significance in relation to the impact on LP's

Simply put, this $150,000,000 of value extracted in the example above wasn't manifested from thin air, it came at the expense of LP providers. In the process of rebalancing pool ratios from one liquidity source with another the value extracted came directly from liquidity providers. This is your hard earned money being bleed dry.

Significance in relation to process inefficiency & wastage

Not only does this process impact the viability, profitability and purpose of liquidity providers, but the process in which this value is extracted is horribly inefficient. Aligning closley with the findings of the research report "A Tale of Two Arbitrages" we see yield allocations of the value extraction process as follows.

• $150 Million value extracted total

• $128 Million combined value to validators & block builders (85.33%)

• $19 Million value extracted as realized net profit by arbitragers (12.66%)

• 100% loss across liquidity pools to which value was extracted

In this scenario:

• Arbitragers eat away at and devalue liquidity positions

• Block builders and validators monopolize block space (eating away at the validators gross profits)

• Liquidity providers suffer impermanent loss resulting from toxic order flow

Conclusion

The problems associated with public order flow in DeFi present significant challenges. Toxic order flow, impermanent loss, and volatility disproportionately harm regular LPs, making liquidity provision less attractive. Additionally, the suboptimal process of arbitrage, exacerbated by PGAs, leads to substantial wastage of extracted yield, with validators and block builders capturing the majority of the value.

Addressing these issues requires innovative solutions to protect LPs and improve the efficiency of value extraction in the DeFi ecosystem, and with that, our opportunity is realized. Read on to discover how we capture this opportunity in our solution.