HOT Powered By Arrakis: An MEV Aware, Intent-Centric AMM Design

HOT is an AMM providing optimized returns for LPs and token issuers through a first of its kind intents-aligned approach to on chain liquidity. HOT was created by Arrakis and Valantis Labs.

For a more technical and in-depth overview check out the HOT Paper.

HOT Introduction: The Journey to Becoming HOT

Any trading venue whether it be for equities, digital assets, trading cards, used Hondas needs to win on two axes to be successful: liquidity & flow. Liquidity simply refers to the amount of assets available to facilitate trading which is a direct proxy for improving pricing and decreasing volatility. Flow is the other side of the equation and refers to the amount of trades routing through said liquidity source. One begets the other. More flow, more liquidity. More liquidity, more flow.

At Arrakis we spent much of 2023 thinking about ways to “fix” the AMM problem from these two vectors of liquidity and flow. There’s been quite a bit of discourse around how sophisticated actors have exploited price discrepancies on Binance vs. Uniswap at the great expense of on-chain liquidity providers, the LP. There have been many different attempts to quantify and name this phenomenon which has included an alphabet soup of jargon like Loss Vs Rebalancing (LVR) and Maximal Extractable Value (MEV). It can also be simply referred to as “toxic flow” or trades that exploit price discrepancies. Many players at the bleeding edge of AMM development, including Arrakis, are actively looking to mitigate “toxic flow” stemming from sophisticated arbitrageurs.

But at Arrakis we identified another problem (and opportunity) that we believe can help answer the question of “how do we attract even more non-toxic flow?”. Throughout the last bear market there was a trend emerging behind the scenes for where swaps were being routed. Most users are familiar with the Uniswap front end or aggregator front ends like Defillama or 1inch. However, most users are probably unaware that more and more of these trades from aggregators aren’t being split up across Uniswap or other permissionless publicly accessible DEXes but are rather being routed through a new emergent class of on-chain liquidity providers called “Private Market Makers” or PMMs.

Overall PMM volume grew from $500M in January 2023 to $4B+ in March 2024
Overall PMM volume grew from $500M in January 2023 to $4B+ in March 2024

The actual entities behind these PMMs aren't that new at all – they’re the same big players who provide liquidity on Binance and other centralized exchanges - the “Market Makers”. Historically this has included names like Jump, Jane Street, GSR, Alameda, and Wintermute. As of today one of the few still standing from the last bull market and the most notable on-chain contributor is Wintermute (in the graphic below Wintermute encompasses all three of the green rectangles).

Almost 50% of Intent Protocol flow is landing on PMMs. Wintermute's PMM is comparable in size to the UniV3 AMM.
Almost 50% of Intent Protocol flow is landing on PMMs. Wintermute's PMM is comparable in size to the UniV3 AMM.

On the right side of the graph you can see the proliferation of PMMs who are ultimately market making for all the flow (trades) routing through the three major Intent Protocols. The Intent Protocols account for a significant amount of all on-chain flow. At Arrakis we believe the PMM trend is here to stay. In other words less and less flow (and the potential fees they represent) is going to occur on standard AMM pools like an ETH-USDC position on UniV3. Any AMM design that wishes to attract more flow must play ball with the new PMM landscape we live in.

To summarize the problem - retail LPs on traditional AMMs are receiving an increasingly large percentage of toxic flow from arbitrageurs (retail is getting wrecked). At the same time most of the good flow is captured by PMMs (accelerated by the adoption of Intents Protocols) which are thus far dominated by a walled garden of professional market making actors.

HOT Explained: HOT is a first of its kind MEV aware AMM design that drives better outcomes for LPs by merging the benefits of PMMS with the permissionless nature of traditional AMMs which in practice will protect LPs against toxic flow and attract more good flow.

HOT stands for Hybrid Order Type and references the fact that this AMM has a hybrid or dual approach to processing trades. On the one hand there is a normal AMM swap, almost identical in experience to Uniswap, by which anyone can permissionlessly trade against the pool. Where HOT differs though is in the second type of swap dubbed “flash swap”. The flash swap, similar to PMMs, operates through an RfQ (request for quote) system. This novel RfQ system, also known as the Arrakis Quoting Service, allows permissioned solvers to receive a guaranteed or deterministic quote to trade against the pool.

What are the flash swap benefits to LPs? In short flash swaps will bring more volume, more fees, and more arbitrage protection to the LPs.

Volume: LPs will receive more flow that would have otherwise gone to a different PMM (not to a regular AMM)

Fees: LPs will earn fees on this flow

Arbitrage Protection: The flash swap also requires the Solver to push an Arrakis validated price update to the pool’s state (ideally getting the price as close to the price on Binance or other leading CEXes as possible). In addition to the price update the Solver will also update a dynamic fee that will increase over time in between flash swap orders to further protect against arbitrageurs as the price becomes more stale over time.

What are the flash swap benefits to Solvers?

Solvers will primarily benefit by receiving a deterministic quote at a competitive price. Solvers prefer deterministic quotes because in many cases they are sourcing liquidity through other routing options that are only “probabilistic” meaning their profit margins or ability to successfully fulfill a CoW Swap auction quote aren’t guaranteed. The certainty provided by HOT will create incentives for Solvers to frequently bid with the Arrakis Quoting Service.

How much will LPs benefit?

According to Columbia University professor and a16z researcher, Tim Roughgarden it is believed that LVR (toxic flow) is costing LPs on ETH-USDC 11% of their principal per year. Based our estimates we believe HOT can reduce LVR exposure by 50-90%. For LPs this could effectively translate to a 5.5% increase in yield per year. Arrakis plans to release more granular backtesting prior to launch.

HOT Implementation: HOT Gains Summer

HOT was built by Arrakis and Valantis Labs. HOT is the first DEX integrated into the new version of the Arrakis Protocol and the first DEX to exist on top of Valantis Lab’s Sovereign Pools which are a modular generalization of DEX architectures, allowing for non-fragmented liquidity across a composable system of pools and modules. HOT is currently under audit and expected to launch in late Summer 2024 whereby LPs on Arrakis will be able to get exposure to best in class LVR mitigated returns.

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