The Next Horizon

Mark Lurie

• 4 min read
The Next Horizon

DeFi Is Falling Short

Fair and free markets create shared prosperity, and prosperity empowers people around the world to advocate successfully for their own political and human rights. The promise of Decentralized Finance (DeFi) is that it enables open, global exchange, providing access to the transformative power of markets even when incumbent power structures want to limit individual access.

However, DeFi has a big problem: most DEXs are not sustainable because liquidity providers (LPs) are losing money in their pools without artificial liquidity mining incentives. If LPs lose money, liquidity could flee, breaking the system. In crypto, we’ve become so accustomed to endless liquidity mining and zero protocol fees that we may not stop to wonder why these gimmicks continue without end. Simply put, initially, they may bootstrap liquidity, but they become endless when they retain LPs who aren’t actually profiting on their deposits. This becomes obvious as you analyze the blockchain data itself (e.g., this great twitter thread). Simply put, impermanent loss far outweighs fees for LPs–a condition best measured with Loss Versus Rebalancing, or “LVR”, which measures an LP’s losses relative to a standard benchmark, that of a similar rebalancing portfolio.

Until now, this unsustainable system has gotten by because low-interest rates have allowed for high token values and endless liquidity mining. But on-chain risk-free rates are rising as ETH staking is now liquid and U.S. Treasuries are coming on-chain. This will make lazy liquidity increasingly difficult to retain, especially in ETH<>USD stablecoin pairs, which make up 70% of Uniswap volume. Liquidity winter is coming. When it arrives, it could end the dream of DeFi.

Building for LP Profits

The team at Shipyard Software (the builders of Clipper DEX) believes in the promise of fair and free markets.  My co-founder, Abe, and I met 20 years ago as undergraduates at Harvard. Since then, we’ve both spent time in venture capital and have founded multiple startups with exits. Abe’s Ph.D. research is seminal work on automated market making and is widely cited in the DeFi space, including in Uniswap’s whitepapers. We felt we had the experience to solve this problem.

Our first task for building a DEX with sustainable LP profits was to diagnose the problem in detail.

It turns out, most LP losses are incurred on swaps between pairs of blue-chip tokens (such as ETH and BTC) and USD stablecoins (“blue-chip swaps”). Blue-chip<>USD stablecoin swaps (i.e., Clipper Core pairs) made up ~70% of all DEX volume this calendar year, so whatever happens on these pairs dominates overall returns. The problem is that prices for most blue-chip tokens are formed off-chain on centralized exchanges, then brought on-chain by arbitrageurs who take stale prices offered on DEXs with LP capital. This drives negative returns for LPs because they are systematically taking bad trades. It’s impractical to try to generate enough fees to offset these losses even with huge volumes – the math just doesn’t work. This isn’t as big of a problem for swaps between stablecoins (“stableswaps”) because their prices are known to revert to 1:1. Curve is a great design for these types of swaps. It also isn’t a big problem for long-tail altcoins (“altswaps”) because prices form on-chain and thus aren’t as susceptible to toxic arbitrage from centralized exchanges. For those types of swaps, Uniswap is a great design.

We recognized the importance of building a sustainable solution for blue-chip swaps. We saw the enormous impact it could have and decided there was great potential for such a platform to become a top DEX (alongside Curve for stableswaps and Uniswap for altswaps). In fact, there was potential to be even larger since blue-chip swaps dominate DEX trading volume. The goal was to ensure sustainable returns for LPs through efficient execution of blue-chip swaps. These go hand-in-hand because better returns mean LPs can offer better prices to traders. We had to develop a new DEX architecture, the Formula Market Maker, to do it. You can read about the design here.

After two arduous years and five versions, Clipper is battle-tested and proven:

Here’s why LPs want to park their blue-chip crypto assets in Clipper’s pools:

  • If you only HODL your crypto, you’re missing out on yield. This could be better.
  • If you stake ETH, you’re settling for ~4% instead of harvesting substantial ETH/USD volatility. This could be better.
  • If you harvest volatility haphazardly by trying to time the market (selling high and buying low), you’ll probably get it wrong. This could be better
  • If you harvest volatility systematically by manually rebalancing your portfolio you’ll pay transaction costs that drag on your returns. This could be better
  • If you harvest volatility systematically by passively LP’ing in a CPMM like Uniswap, you’ll rebalance at systematically bad prices, losing more to impermanent loss than you gain from fees. This could be better
  • However, if you park your blue-chip assets in Clipper, it will passively rebalance your portfolio daily at correct market prices with zero transaction costs. This seems like the best option.

Sailing New DeFi Seas

Shipyard Software has proven Clipper works, now, it’s time to scale Clipper to deliver the impact it was designed to achieve. But we can’t do that alone, and for regulatory reasons, you should not expect Shipyard to whatsoever. That’s why the community, through AdmiralDAO, is taking control of Clipper’s future. Decentralized governance is the key to achieving the kind of scale necessary to become a Top  DEX.

To become the Curve of blue-chips - and a top  DEX - Clipper needs to address larger trades with less slippage, which requires more liquidity. Armed with the best prices Clipper can attract the majority of blue-chip volume from DEX Aggregators, like 1inch and UniswapX. We propose a target of $50M as the community’s first mission. Accomplished through the DAO, this will deliver sustainable blue-chip swaps to the world of DeFi. Shipyard Software has backtested 1inch data, which shows more liquidity almost immediately attracts enormous volume.

On-chain rates are rising, so now is the time to manifest the sustainable DEX solution that DeFi so desperately needs. That’s the only way we’ll bring fair and free markets to the world and create the change we know is not only possible but just around the corner.