Volumes & “The Bot Game”

Most people who track the DEX space focus on volumes as an indicator of success. However, this gets tricked by The Bot Game.

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How The Bot Game Works

Imagine a new DEX launches and charges a fee on every trade. Part of the fee goes to token holders of the DAO governing the DEX and part goes to liquidity providers as yield. Since the tokenholders know that most people who track the space focus on volumes (and the DAO gets a fee on each trade), they are happy to maximize volumes. It turns out there is a simple way to capture enormous volumes–allow trades that lose a little bit of money. Within days, bots and arbitrageurs flood in taking the other side of those trades. Volumes skyrocket, and Crypto Twitter  is buzzing about the DEX. The market thinks this DEX is the next big thing and demand for  its token increases. This is The Bot Game in action.

There is a glaring  problem here: LPs are losing money on all of these trades. At some point, the money will run out and the LPs will leave.To prevent this spiral, the DAO tries to mitigate the problem. First, it points out that enough fees can theoretically cover the losses.However, since this has almost never actually occurred, the DAO saves face by reporting LP APYs that are calculated by dividing fees by principal. This method of calculation has the convenient characteristic of only  producing positive numbers(mathematically the results can never be negative), thereby obfuscating any losses. Second, it subsidizes LPs by giving them DAO tokens (yield farming). In the short-term, everyone is happy–massive volumes drive token price appreciation, making the token subsidies even more compelling. This positive feedback cycle seems ingenious and VCs gush over the DAO’s ability to “bootstrap liquidity”. 

To be fair , “bootstrapping liquidity” could be a useful tactic. In a time of rapid market expansion, it allows for acquiring users and market share faster than competitors. Yet, there is a subtle but important difference between bootstrapping and building a house of cards; the difference hinges on whether the underlying economics are profitable or not. If the economics are not profitable for both the protocol and  its LPs, then if the market ever falters in its demand for the token the feedback cycle can quickly become negative. In other words, The Bot Game is reflexive.

If this sounds familiar, it’s exactly what SBF did. FTX lent customer funds to Alameda, which then used these funds to make money-losing trades on FTX. This attracted explosive volumes from market makers and other arbitrageurs and SBF became the talk of the town, pulling in billions in venture capital investment. Until the market faltered; customer money had run out and FTX quickly spiraled.

If the underlying economics for LPs can be positive without artificial incentives, then a faltering market would simply result in lower but still positive yields (the premium over competitors with negative yields might even widen) and liquidity would likely stay. That’s real bootstrapping.

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How Big Is The Bot Game?

The unfortunate reality is that the vast majority of tradeflow  on Uniswap, Trader Joe, PancakeSwap, etc. is bot flow. It turns out measuring volumes tells you absolutely nothing about the real value the underlying DEX provides to LPs. Toxic bot volume simply dominates legitimate human trader volume. This makes judging market share by volumes simply irrelevant. Here’s a chart from a Glassnode report that really drives the point home:

In spring 2022, we learned this firsthand. A new version of Clipper was deployed that inadvertently created a perfect experiment. When the new version first launched, volumes grew to $400M per month. However, LP yields were not performing, so after some analysis we tried a few things. For example, we deployed new code that blocked any money-losing trades (e.g., where oracles indicated the output value exceeds the input value) and we added some simple heuristics to fail bot-initiatied transactions (they aren’t hard to identify on-chain). Immediately, volumes dropped by 10x, but LP profit yields became positive and compelling. In other words, these adjusted volumes were real.

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Bad Data Is Worse Than No Data

Relying on bad data is worse than relying on no data because people tend to manage what they measure. So bad data will systematically bias you into bad decisions. Whether you’re a DAO, an LP, or a token holder, it’s better to ignore BS. Sure, the market may value ‘volumes’ now…until suddenly it doesn’t and you’re stuck holding the bag. Just like FTX. Or Terra. Or 3 Arrows. Or Celsius. The list goes on.

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There Is a Better Way

So what should you measure instead? Brace yourself, this may blow you away: PROFITABILITY is the best indicator of sustainability. For LPs, measure LP profit yield against a benchmark. For DAOs, measure protocol earnings. If either figure isn’t reported, it’s fair to assume it’s because the number is bad.

This is why Clipper reports profit yield for LPs and DAO protocol earnings (via token terminal). Long-term success will only result from building in a sustainable way.Change starts here at AdmiralDAO, the DAO for DeFi Builders.