The two reasons why batch-auctions eliminate the wasteful and socially harmful arms-race is that they eliminate tiny speed advantages (if trades are settled every second or tenth second, nano-seconds do not matter) and it shifts competition from speed to competition for price.
However, existing exchanges do not have sufficient incentives to adopt such new market designs precisely because they are able to extract rents from the inefficiencies that these alternatives are aiming to eliminate.
Miner extractable value (MEV) on blockchains
Blockchains and their financial applications have their own set of issues. Existing blockchains ignore the challenge of ordering transactions in a fair manner to a large extent and mostly provide explicit ways to front-run based on the fact that users can get their transaction included earlier by paying a higher gas/transaction fee than someone else in e.g. Ethereum.
Based on this, the issue of excessive miner extractable value arises (MEV, Flash-boys 2.0). MEV is the profit a miner, or other privileged protocol actor in consensus like validators in proof of stake, can make through arbitrarily including or reordering transactions from blocks they produce. Today mainly traders extract value from front-running strategies, with miners benefitting from the increased fees from gas races. However, it is likely that miners will increasingly run such strategies themselves. There are significant negative externalities caused by these possibilities in the form of clogging up the mempool and block-space as well as the resulting fee spikes. Projects such as flashbots aim at democratizing the practice and at least reduce such negative externalities, while not eliminating the root-cause.
Fairness in Vega’s protocol design and efficient market design
Definitions of (relative) fairness
Vega solves for relative fairness — ways to assure that the relative order of transactions is fair. The goal is to build a module that can be added to existing blockchain designs — “Wendy the good little fairness gadget”.
The exact definition of fairness that is required for specific applications can differ. Thus, Vega intends to provide a library of fairness pre-protocols run by validators in parallel to the actual blockchain for markets building on the blockchain to choose from.
Wendy basically creates virtual blocks of transactions that need to be scheduled together in order to comply with the specific fairness rules in question.
Vega targets that if a transaction within a given market is sent to the network first, it is also executed first without major impacts to latency as a standard. However, the exact definition of relative fairness has a couple of subtleties.
Unfortunately, the ideal property of “If all honest parties saw transaction a before transaction b, then a is executed before b” is impossible to achieve even if only one validator is not acting honestly.
The second best approach is to guarantee that transactions a and b are at minimum settled in the same block, which is possible, but leads to deprecated performance, as there is no limit on when requests are delivered or how big a block becomes. Cornell researchers also suggest this type of fairness in a recent paper.
To resolve this challenge, Vega is proposing a definition of relative fairness around the use of local time, which can be guaranteed without deprecating performance significantly. “If there is a time t such that all honest validators saw a before t and b after t, then a must be scheduled before b”. There is no need for the local clocks to be synchronized, however the definition does make more sense in practice with roughly synced clocks (as otherwise delays happen).
For an improved trade-off, their current approach is a hybrid of block fairness and fairness around local time. Under normal operation, the protocol will guarantee block fairness. However, if a performance bottleneck is detected (through a threshold of delayed requests due to impossible fair ordering), the latter approach is utilized on a limited time-scale.
Fair, decentralized trading protocols to prevent front-running in CLOB
Different markets might require different definitions of fairness and not all transactions need to be ordered fairly against each other, so every transaction can get one or several labels in order to be scheduled accordingly. For example a market for wheat futures would not interfere with derivatives on gas fees on Ethereum.
Wendy only assures block order fairness, but a block contains enough information to also assure (some) fairness between individual transactions so that front-running and latency arbitrage becomes impossible or at least unlikely to be successful in most cases
It could be possible however, for well-resourced participants to operate clients on high speed connections at the minimum distance to the majorities of validators, which could initiate a similar arms-race as described earlier. To counter that a (random) value of 1 − 10 milliseconds to the timestamp of each received transaction, would eliminate the business case of spending shaving off nanoseconds.
Low barriers to entry & aligning incentives with LPs for more efficient markets
On Vega, being a permissionless trading protocol, anyone can launch a market with highly customizable design patterns, including frequent-batch auctions (watch co-founder Barney discuss the targeted use of auctions). The low barriers of entry coupled with the fact that market creators that will be the first committed liquidity providers reap the largest share of fee revenues should lead to healthy competition between market designs that ultimately would lead to an elimination of excessive rent seeking through extractive market practices.
The competition shifts from a timing arms-race to an arms-race in launching well-designed markets that cater to user needs in the best way possible, as LPs become market operators.
LPs need to make a financial commitment (bond) to provide liquidity at a certain level — the bond determines how much liquidity an LP provides — in order to receive rewards, while being penalized for not upholding the commitment. Vega will automatically size orders, as long as sufficient margin is provided.
Incentives to join early — a land-grab for novel derivatives markets
The more liquidity an LP provides and the earlier she joins a market, the more LP shares she receives and the higher percentage of the trading fees from price takers she receives.
Liquidity is not only desirable from a trader’s perspective, but it’s also crucial for risk-management. Distressed positions can only be liquidated if there is sufficient volume on the order book to offload it.
Thus, Vega continuously computes whether each market has a sufficient level committed, while placed into a liquidity monitoring auction, when deemed insufficiently liquid. The liquidity requirement is based on the maximum open interest observed over a rolling time window.