Is Complete Decentralization Necessarily Good?

— An overview on Konomi Swap platform and community governance —

2020 has undoubtedly been a year of rapid growth for DEFI crypto exchanges, with enthusiasm for DEFI projects peaking as leading DEFI platforms such as Uniswap launch a more flexible and in-depth version of the market. DEFI market participants are beginning to believe that a fully-decentralised financial era has arrived and that centralised trading is merely a relic of history. However, according to the latest data, the highest single-day trading volume on the fully-centralised exchange Binance topped $80 billion, compared to leading decentralised exchange Uniswap, which only surpassed $50 billion trading volume in late 2020. The fundamental reason is that the current fully-decentralised exchange relies on an AMM model that requires extremely high Gas fees, thus needing constant upgrading and a more robust price-feeding mechanism. Hence, the Konomi team believes that based on the current market situation, a fully-decentralised trading platform is not the optimal solution for the Swap market. The optimal solution for the DEFI Swap Market is a Swap platform that is based on the DEFI framework and can be transformed into a fully-decentralised trading platform in the future when time is right, while still applying the proven tools of existing centralised exchanges at some point during the process. The text below will provide an overview of the Konomi Swap design and the expected product to be launched by the Konomi team in the near future.

  1. Token Liquidity Pool

Firstly, similar to traditional DEFI projects, the Konomi Swap platform will have a token liquidity pool, which will be divided into two parts, each representing a different token. In Konomi Swap V1, it is expected that only DOT and ERC20 tokens will be exchanged, while in V2 we expect to add ERC20 to ERC20 exchanges. However, unlike platforms such as Uniswap, Konomi will not allow users to launch their own token pools for token exchanges on the platform without obtaining any official permissions, because such actions would allow many speculators to create a number of “fake” ERC-20 Tokens. These fake tokens would be meticulously packaged to look like real tokens to lure investors into trading and then dumping all of their fake tokens through the Swap platform. While platforms such as Uniswap are currently based on a completely decentralised product design that requires users to take on the responsibility of identifying whether the ERC20 tokens available in the trading pool are real, Konomi believes that users should not be imposed of such risks and that a user-centric platform should ensure that its products are “qualified”. A platform full of “unqualified” tokens will end up with “qualified” tokens being forcefully driven out of the platform. For this reason, the Konomi platform will require users to contribute a certain percentage of Kono to the platform’s collateral pool when creating a trading pool, which the platform has the right to confiscate in order to compensate investors should the pool is suspected of fraud and other illegal activities. In the future, if the blockchain authentication system can be further improved to prove that the creator of the pool is of good credibility, this mechanism could be omitted to allow users to create trading pools freely.

  1. Basic Model

The Konomi platform will still use the AMM model which is currently the most widely used model in the DEFI market, and the basic model will still be the most widely accepted constant product model. The key to choosing this model is not that it is the most perfect existing model, but rather that it has one of the greatest advantages of being able to provide infinite liquidity (a detailed derivation will be provided in the appendix). However, no financial model is perfect and in exchange for infinite liquidity, the model comes with trading slippage and may incur potential losses (a detailed derivation will be provided in the appendix)

First and foremost, why is infinite liquidity so important? Liquidity is the fundamental basis of all Swap actions. If an exchange (whether centralised or decentralised) is not supported by liquidity, it will lack the necessity for survival. Any swap action can be seen as a process of providing and consuming liquidity, which a centralised market describes vividly as making the “lowest point lower and the highest point higher”. The decentralised market, on the other hand, describes this as a process of transferring “active water” from one pool to another. The most fascinating aspect of the constant product model is that it provides a pool that can never be filled to the brim, thus solving the problem faced by order books for trading mandates in traditional centralised exchanges.

However, there is no such thing as free lunch in the financial market and thus infinite liquidity will bring with it the inherent problem of slippage and potential losses. According to data from Peanut.trade, the total slippage loss on Uniswap last October was over $66 million, 3.5 times higher than the transaction fees during the same period. Out of which, over 30% slippage was on the WETH/CBIX7 trading pair, which means that users paid around $9,800 more per trade, while the total slippage of the most popular WETH/USDT trading pair was close to a staggering $7 million. To address this issue, the Konomi team will be considering the adoption of “liquidity amplification” in mainstream trading pairs to improve the current situation. To put it in a simpler way, by focusing on liquidity within a specific range, the Konomi platform will work with our partner Chainlink to use a price Oracle to ensure that the pricing curve in the liquidity pool is dynamically updated so that asset prices can be on par with market prices, thus reducing slippage. Of course, slippage cannot be completely eliminated (if arbitrageurs were eliminated then there would be no incentive).

Moving on to minimizing potential losses, as a liquidity provider, since the current Uniswap model always relies on arbitrageurs to eliminate imbalances in the pool, the provider will always be on the “opposite side of the truth” for every trade. As a compensation mechanism, 0.3% of the transaction fee will be awarded to liquidity providers as an incentive. This potential loss may or may not be reversed into a gain in the future. In our opinion, the current problem of potential losses is very unfriendly to liquidity providers that are looking for a stable return, because firstly, all of the liquidity providers’ earnings are floating profits until the pool is closed and are thus highly likely to evaporate in a short period of time (unless users enjoy trading in the global markets 24/7/365). Secondly, all of the providers’ funds will be locked up in the pool but not in their own wallets. To address these two issues, the platform will first allow liquidity providers to close their liquidity pools temporarily so that they do not have to be paranoid constantly. At the same time, Konomi will offer an incentive to liquidity providers who choose to trade 24/7/365 (any risk taken should be reasonably rewarded). The second step is to set a safety ratio that allows the providers to withdraw a certain amount of profit into their own wallets and turn it into actual profit while still maintaining the liquidity of the trading pool.

  1. Community Governance Model based on DAO Framework

The community governance of the Konomi platform is based on a DAO (Decentralized Autonomous Organization) framework. Compared to traditional financial systems where financial regulators often review and regulate the issuance of financial products such as stocks and bonds, a DAO-based financial system has the significant advantage of automated enforcement of uniform rules, transparency, and the ability for any stakeholder holding a Kono token to voice their wants and needs. We believe that a DAO-based community governance model will not only increase the liquidity of Kono tokens but also significantly increase users’ level of participation.

In our opinion, the biggest problem of establishing a decentralised community based on DAO is not technical-level issues, but rather the lack of relevant data which will enable all decisions to be quantified by smart contracts. Related projects have shown that a community governed entirely by automatically executed codes does not reduce the cost of interpersonal communication, especially when dealing with extreme events. Taking a simple example to illustrate, the basic guidelines for DAO governance are still as binary as the options of ‘0’ and ‘1’, black or white. As financial markets are often fast-changing and extremely complex, it would be unfair and inefficient to leave the question of whether a token can be used as collateral entirely to the users who hold it, with only two extreme options available. If the vast majority of users do not have a good understanding of the token, then such voting is clearly unfair and inefficient.

Therefore, our team believes that a more realistic and efficient approach is to combine rule of man and autonomy, in which rule of man will deal with non-quantifiable, high-frequency decisions and autonomy dealing with quantifiable, low-frequency decisions. When the community is faced with a new problem that is not stated into the smart contract, it is necessary to bring in rule of man to write a smart contract that can handle this type of problem in order to provide a standard solution for similar problems in the future. As more of these problems are continuously identified and solved, the degree of involvement of rule of man will eventually become lesser until it is entirely diminished. Autonomy, on the other hand, mainly deal with problems such as Swap and liquidation procedures that can be standardised and designed in advance. Currently, most of the governance of the Konomi platform can already be solved by smart contracts.

  1. Conclusion

As faithful believers of Web 3.0, everyone in the Konomi team believes that complete decentralisation in the financial industry is definitely the trend of the future. However, we do not agree with the current rhetoric against centralisation, which delivers the idea that centralisation is entirely harmful. The Konomi team has always designed its products with users as the priority, and has never tried to entice users by promoting a brandnew concept, only to introduce an immature product to market and leave the users in a complete mess after successfully making profits. The Konomi team’s Swap platform and community governance may not be the most conceptual product in the DEFI market, but it will be the most responsible and stable option. The Konomi team will never stop innovating and upgrading, yet upholding the belief that the cost of innovation should be borne by the team and not imposed on users of the platform.

Appendix:

  1. Derivation of infinite liquidity:

Assume that there is currently a liquidity pool of DOT-BNB transactions on Konomi platform and that users need a method to determine the price of the transaction when trading DOT for BNB.

The core idea of Konomi’s pricing model is similar to the more established Uniswap model and is a constant product formula X×Y=k(Refer to graph below for function illustration)

(In the graph above, the X-axis represents the number of X tokens and the Y-axis represents the number of Y tokens)

Assuming that the product k is a constant quantity, when a user uses asset x to redeem asset y from the liquidity pool, the number of assets in the liquidity pool increases by x and decreases by y. Since k is constant, when x grows by∆X, y needs to be reduced by∆Y in order to keep the equation constant.

Without considering transaction fees, this satisfies:

(x+∆X)×(y−∆Y)=k

Considering transaction fees, this satisfies:

[x+ΔX (1-γ)]×(y−ΔY)=k′

In whichγ represents transaction fees

Calculation of transaction price:

Without considering transaction fees:

α= β=(α、βare the variance per transaction respectively)

Referring to 3.1, we know that

x′=x+∆x=(x+αx)=x(1+α)= x

y′=y−Δy=(y-βy)=y(1-β)= y

∵Δx=αx,x′= x(1+α)= x

∴(1+α)=

α=

∴Δx=x

Similarly,

Δy=y

The following function graph depicts the situation where ΔX is put into the liquidity pool to redeem ΔY.

As shown in the graph above, the more ΔX you inject into the liquidity pool, the more ΔY you can take out of the liquidity pool, but ΔY will only keep approaching the number of tokens available in the liquidity pool and will not surpass it, which means that users can never buy out all the tokens available in the liquidity pool at once. As such, it is proven that the constant product formula provides infinite liquidity.

  1. Trading Slippage:

Trading slippage refers to the difference between the actual price paid and the desired transaction price when buying or selling a currency.

To purchase ΔY from the flow pool, users need to pay ΔX, so the price of this purchase is

∵Δx=αx Δy=y

∴P===(1+α)

∵P′= represents the asset price in the liquidity pool

∴Slippage(Q)= P−P′=(1+α)P′−P′=αP′

The above formula shows that slippage Q is linearly related to α=. It can be seen that the greater the amount of money in a pool, the smaller the slippage will be (the larger the x, the smaller the Q), while the smaller the volume of transactions within a point in time, the smaller the slippage will be (the smaller the Δx, the smaller the Q).

  1. Potential Risks:

Minimizing user’s risks is always the top priority of Konomi, therefore Konomi will always inform the users of the potential risks of a transaction beforehand, thus helping them to decide whether to trade or not. According to current simulations by the Konomi team, the user’s assets will potentially incur loss in the event of fluctuations in the price of the assets in the liquidity pool, which is illustrated by a case study to facilitate the readers’ understanding.

Assuming that a DOT-BNB liquidity pool currently exists, with d denoting the number of DOTs, b denoting the number of BNBs and p denoting the price in the liquidity pool, and that the user currently injects 100 DOTs and 10,000 BNBs into this pool. Then, according to the following four sets of equations, there should be

d*b=k p=b/d

∴d2=dbbd

d=kp

Similarly, b2=db*bd b=k*p

Based on the assumption above,now d=100 b=10000,the current market price is p=b/d=100

k=db=100*10000=1000000

Suppose that there is now a sudden adverse change in the external market, resulting in price p′to become 120. Due to the change in price and refer to descriptions above, the arbitrageur will enter to start work at this point in time, enabling the price in the current liquidity pool to be aligned with the external market, at which point the latest d, b quantities in the liquidity pool are:

d′=kp=1000000120=91.28709

b′=k*p=1000000*120=10954.45115

Now we assume that this liquidity pool did not exist and the user just kept all the currency in their wallet, the value of the money at this point would be:

V0=d* p′+b=100*120+10000=22000

Then after putting the money into the liquidity pool, the user can only have

V1= d′* p′+ b′=91.28709*120+10954.45115=21908.9023

Then potential loss would be

L=V0/V1=21908.9023/22000=99.59%

As such, we can deduce that the potential loss of the user is around 4%, but if the user still maintains the position, once p is able to return to 100, the user will have no loss, which is why we refer to this loss as the potential loss.

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decentralised money market on Polkadot