Gauntlet's report on Thorchains use of slip-based fees.
Thorchain features a fee system that differs from common practices in the DeFi space. Many protocols adopt a model similar to Uniswap, with a flat trading fee (commonly around 0.3%). Interestingly, Balancer also has a unique set up, with Pool creators having the power to set their own fees. However, Thorchain charges traders (swappers) a fee based on the amount of slippage that their swap will cause. Gauntlet recently released a report on this set-up.
- Link to the full report - all quotes in this post are sourced from this report.
The full report goes in to all the detail of how they modeled the fee system, compared to the market norm of a flat 0.3% swap fee and the assumptions and systems they used to model it. I won't go into too much detail there, my interest is basically to look at the key take-aways from their analysis:
As you can see from the heat maps in the previous section, the slip-based fee improves the expected returns for liquidity providers in most market conditions. The fee model does well when there is high volatility between trading pairs, and is able to withstand substantial price drift. Almost all price movement that is not mean reverting is bad for a standard XYK exchange. However there are many price trajectories where THORChain LPs are still able to make a profit despite lack of mean reversion. Impermanent loss is greatly reduced, but not eliminated.
The slip-based fee does disadvantage THORChain in a highly competitive market for trading volume, as large trades will be cheaper with a fixed fee. Prices on the exchange still remain competitive for smaller trades, with arbitrageurs able to keep prices close to the values on other exchanges. Arbitrage profits are better in the XYK exchange, but thatโs the whole point of the slip-based fee and we still see prices stay in sync as arbitrageurs can still make money, though not as much. As returns to LP providers appear to be much stronger, the liquidity on THORChain should improve to the point where it offsets the fee for larger and larger trades. If THORChain is able to attract sufficient liquidity, organic demand will favor trading on THORChain.
The comments above show again that Thorchain has been designed with Liquidity providers as the key to the system. The "LP's are the first class citizens" mantra has been coming from the team for a while now, this report is more evidence that that is the case. The fee model, when combined with Rune token emissions, means that Impermanent Loss will be lower over time in a RUNE pool than LP's would experience elsewhere.
As the review highlights, the slip fee can disadvantage the system with regards to large trades. Traders will go where the slippage and fees are lowest. If Thorchain does not manage to build it's liquidity depth significantly, there is a risk that the system will not be attractive to traders wanting to make larger trades. However, Arbitragers will still trade the pools, as any price difference between Thorchain and other markets will always see arbitrage action. The fee structure of Thorchain means that instead of LP's essentially losing out to arbitragers, they benefit from this trade and the fee income offsets their potential Impermanent Loss.
The final conclusion is that If Thorchain can attract enough liquidity, it will be a favorable place for trading as deep liquidity will mean smaller slippage based fees than elsewhere.
Why will Thorchain attract enough Liquidity?
At this point, there exists a Twitter thread produced by Andrew Kang which explains the theory that Thorchain will become a "Liquidity black hole" sucking in assets constantly over time.
๐ฐ๐LIQUIDITY BLACK HOLE THEORY ๐๐ฐ
โ Andrew Kang (@Rewkang) June 15, 2020
There exists a token-based AMM design ๐ ๏ธ
That threatens to create a liquidity blackhole ๐ณ๏ธ
Pulling in assets from everywhere ๐
CEXs, DEXs, Cold Storage, etc. ๐๏ธ
I'll break it down ๐
If anyone is curious about why Thorchain will succeed, this thread is a must read. Reading and absorbing this thread was the lightbulb moment for me, and a huge reason why I am so bullish on RUNE. If you haven't yet, please read the thread. It explains and highlights the Liquidity Black Hole theory much better than I could.
Once again, independent analysis confirms that Thorchain LP's are the first class citizens of Thorchain.
Thanks for reading,
JK.
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