Bankless - Hasu & Hart on Oval & The Recapturing of Billions in DeFi Liquidations

Episode Date: February 13, 2024

Today on the show, we’re talking about Oval, a new DeFi primitive that Hart Lambur from UMA is introducing to the world of DeFi’s biggest lending markets. Billions of dollars have been liquidated from protocols like Aave, Compound, and MakerDAO over the years, and these liquidations have been extremely inefficiently priced, due to reasons! Reasons that we will discuss here on the show today.  Hasu also joins us on this conversation today to discuss the way that MEV share from Flashbots is a part of this conversation, and he helps illuminate what this means for DeFi going forward as a whole. ------ ⛓️ Visit dydx.exchange to learn about dYdX Chain https://dydx.zone/3SfJTP7  ------ 🎧 Listen On Your Favorite Podcast Player:  https://bankless.cc/Podcast  ------ BANKLESS SPONSOR TOOLS: 🐙KRAKEN | MOST-TRUSTED CRYPTO EXCHANGE https://k.xyz/bankless-pod-q2    ⁠  🔗CELO | CEL2 COMING SOON https://bankless.cc/Celo    🗣️TOKU | CRYPTO EMPLOYMENT SOLUTION https://bankless.cc/toku    🛞MANTLE | MODULAR LAYER 2 NETWORK https://bankless.cc/Mantle    💸 CRYPTO TAX CALCULATOR | USE CODE BANK30 https://bankless.cc/CTC  🦄UNISWAP | ON-CHAIN MARKETPLACE https://bankless.cc/uniswap  ------ TIMESTAMPS   0:00 Intro 7:15 MEV & Oracle Foundations  11:19 Why Solving MEV is Important 21:16 High-Level Patterns  28:19 The Oval Mechanism  42:23 MEV Share Parameters  48:36 Decentralization of the MEV Share  54:30 Auction Length 56:08 Oval B/D Adoption  58:05 Uniswap v4  1:02:31 Oval Cut Upside 1:05:45 Future Questions to be Answered  1:08:42 Closing & Disclaimers  ------ RESOURCES What is SUAVE? FlashBots Phil Daian and Andrew Miller explain https://youtu.be/j3ZM2ZdUWXU  Oval  https://uma.xyz/   https://twitter.com/UMAprotocol   Hart  https://twitter.com/hal2001   Hasu https://twitter.com/hasufl   ------ Not financial or tax advice. See our investment disclosures here: https://www.bankless.com/disclosures ⁠ 

Welcome to Bankless, where we explore the frontier of Defi market structure and capital efficiency. Today on the show, we're talking about Oval, a new Defi primitive that Heartlambor from Uma is introducing to the world of Defi's biggest lending markets. Billions of dollars have been liquidated from protocols like Ave, compound, and Maker Dow over the years, and these liquidations have been extremely inefficiently priced due to reasons, reasons that will be discussed here on the show today. The long arc of Defi has been one that trends towards capital efficiency, efficient price discovery, and ultimately better quality products for its users. This episode today discusses a new mechanism to further Defi's maturity on this very important arc. Hazu also joins us on this conversation today to discuss the way that MEV share from FlashBoss is a part of this conversation, as well as helping illuminate the further direction that Defi is going forward as a whole with mechanisms like this. One more part to this conversation that I want to add here that was unsaid in the podcast.

This conversation is about bringing mechanisms into Defi that allows Defi to leak less value to MEV boss, allowing Defi customers and users to retain all of that value and also increasing the economic viability of the Defi app layer on Ethereum and in Crypto broadly. This is a transfer of value away from MEV arbitragesers to Defi apps. What this ultimately means is that this is a transfer of value away from ETH validators, the ultimate beneficiaries of MEV and towards the users and customers of Defy products on the Ethereum app layer. As long been known, that the ultimate destination of the defy landscape, no matter what chain we're talking about, Ethereum, Cosmos, whatever, is that the value that MEV has will ultimately be retained by the source of that MEV, not by any downstream actors.

The reason for this is obvious. If you're an application that creates MEV, you're also the entity that has the most optionality of directing where, that MEV goes and its conditions for capture. So why wouldn't you just capture it for yourself and improve your bottom line and the quality of your product for your users? This early hypothesis has been stated by many in the MEV world and it's the thing that the Cosmos app chain believers have been chanting about for a while now. And it's being shown to come true within the innovation being discussed today on the podcast. So enough of my table setting. Let's go ahead and get right into the episode with Hart Lamber from Uma and Hazu from FlashBots. But first, a moment to talk about some of these fantastic sponsors that make this show possible, especially Cracken, our preferred

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Bankless Nation, I'm super excited to introduce you to Hart Lamber, the founder and CEO of Uma. Hart, welcome to the show. Thanks, David. Thanks, private me. Hart, we had you on two years ago, I think, to talk about bridges way back in the day. It's good to have you back, my man. Yeah, good to be back.

Good to see you. And a reoccurring guests on the podcast. Well, I guess both are reoccurring, but Hazu's been on a few more times than you, Hart. Hazu, strategy lead at FlashBots as well as just ecosystem, researcher and cryptoeconomic enthusiast, Hasu. Welcome back to the podcast. Hey, David.

Nice to meet you. Hi, Hart. Don't think we've met yet on a podcast, but I'm looking forward to this. I like the cryptoeconomic enthusiast moniker. That's a good one. I think that's a right title for Hazer. I think that's a right title for most people that come on this podcast. But Hauser especially.

That doesn't make it very special, David, you know? The lead cryptoeconomic enthusiast that I know. My preferred. Okay, guys, we're going to get into a conversation that I think bankless listeners will be familiar with longtime bankless listeners. This is inside of the subject matter of M.E.V. Maximally extractable value, minor extractable value, later rebranded to maximally since we no longer have minors in Ethereum. But we're talking about a specific kind of MEV, which has been dubbed Oracle extractable value. So I think this just falls inside of the category of MEP, but it's around a certain

set of how the MEV arises, which is through oracles. And this is going to It would be a conversation that I think talks about the way that applications on Ethereum produce M-E-V through oracles, the sustainability of applications, the healthiness of the aggregate defy applications. A lot of these different subject matters. So it's probably going to be a decently technical episode, but I think we can also make it pretty understandable for people who already know what M-E-V is. Hart, can I ask you to maybe just set up the context of what we are talking about?

about the foundations for what's going on. Like I said, bankless listeners will know what MEV is, but applying it in an Oracle's framing might be a little bit new for them. What is the landscape? What is the problem set that we are going to be addressing here on this episode today? Yeah, absolutely. And we can make it concrete and then maybe generalize it a little bit more, too. But today, Oracle updates, and let's talk about like chain link updates, chain link updates,

drop into the public mempool on Ethereum. Chain link price updates. Price updates, correct. Chain link price updates get dropped into the public mempool in Ethereum, and then they get used by defypike protocols. And if a chain link price update triggers a liquidation, if that price update drops below a liquidation target on an AVE or compound position, that liquidation then triggers a bunch a bunch of things, but basically collateral getting sold.

And it triggers MEV. It's not dissimilar from a user submitting a uniswap trade with slippage into the public mempool, which we all understand creates MEP and like creates a sandwich attack and creates other things where searchers will construct transactions to extract the maximum value possible from that uniswap transaction. Well, basically, we have the same thing going on with chain link price updates, where the chain link price update looks very conceptually similar to an unprotected uniswap transaction with slippage. And it creates MEV that gets leaked and ultimately captured by Ethereum validators. And I believe that the amount of MEV that's captured from Ave compound liquidations can be quite large.

I think this probably happens more. this amount of MEV capture is more when there's times of volatility and probably times of bull markets as well. And really just to set this stage here, we are talking about MEV. We're talking about MEV. We're talking about MEV. This is MEV. We're talking about specifically MEV that happens as a result of price Oracle updates, which most of DFI's chain link. So like Ether is at $1,000. It drops down to very quickly $950. A bunch of DGEMs get liquidated, but then there is the fight to be the liquidator of these positions. Is there like some numbers or some measurements or metrics about like how valuable this MEV is,

like how much values being squeezed out of these applications? Yeah, totally. I mean, estimating MEV is quite difficult. But within like AVE and Compound, we can have a very clear theoretical kind of bound. And the way Avey and Compound work is when a chain link update, price update comes in that causes liquidation, OVey and compound then sell collateral at a discount. And the reason why they sell that collateral at a discount is because they really want to make sure the collateral gets sold to keep the protocol healthy. So that discount is between 5 and 10 percent,

depending on the asset. And if we look back over the history of AVEV2 and V3 and compound V3 over the last about two years, we can see that $150 million-ish of liquidation discounts have been sold. So there's been liquidations, a billion and a half dollars of liquidations that have caused discounts of about $150 million, and that money has been lost to MEV. If we zoom out and go a little bit further and look at kind of, you kind of think of Avian compound since their existence, I think that number is much bigger. It's like quarter million or quarter billion, 300 million type number that has been lost because of liquidations that are really selling collateral too cheap. Hasu, I want to get your perspective on what would happen if this were left unchecked.

Hart talked about some parameters about collateral ether or maybe less liquid assets being sold at a discount. Maybe you could talk about why it's being sold at a discount and why that's important. to the protocol. And then overall, if this version of MEV is left unchecked, Oracle extractable value, like what would happen into the future, because we all want, you know, Ethereum, Defi, any defy in any chain to be the world's global financial system. Why do we have to solve this problem? Why is it important? Yeah. So to your, to the first part of your question, so why is it sold at a discount? I think Hart actually gave a very good explanation here. So when you

want to sell or when you want to buy a token on Unisop and the token is quite volatile and you don't exactly know what slippage to set right and so if you set a very tight slippage then you risk not getting in the next block because maybe the price moves against you right and the same is true for a lending market so if they want to sell a token now they have this trade off between basically setting a higher slippage maximizing the chance to get into the next block or setting basically a lower slippage and risking that maybe the price doesn't take place in the first block, maybe it takes longer time, right? And so you have this.

So it's just a protective mechanism that they need to sell this collateral because they must not have bad debt. Yeah. So, I mean, this is really a design choice by the protocol itself, I would say. So if you're on UNISOP and trading shit coins, okay, so what's the worst that can happen if you don't get to buy this position now? okay, you maybe inquire some kind of opportunity cost. But the lending market, you could argue, has a much higher responsibility to that capital, right? So they manage the money effectively of many different depositors, right? And so if they let someone get away with bad debt, then that has to be socialized somehow.

So in the first chance probably would go, in the first instance, it would probably go to the token holders of that project. is the first line of defense. And if that doesn't help, then at some point, you have to socialize the money on depositors effectively because there's nobody else there, right? In crypto, you don't have any legal recourse or anything like that. And so that's why traditionally landing markets have chosen to be very rigid about how fast they want to liquidate in order to minimize the risk that they internalize. any of that bad that either to their token holders or to even to their depositors.

And I think that paradigm, I guess, is changing a little bit. So I mean, if you look, if you look kind of at the slippage that, for example, a protocol like Avey or compound has been quoting 5 to 10% is a lot. And it's more than maybe they need to. And so they tend to bleed a lot of money by doing that. And we've seen some protocols basically handle this problem by spinning up their own auction mechanisms. Like Maker, for example, Maker has, I believe, a reverse Dutch auction. So basically the money that they, the price that they charge to liquidate this collateral basically starts low and then it increases every block. And so this is at the opposite end of the spectrum, right?

So where compound says, I must liquidate this in one block. And so I'm willing to pay a lot for this. Or I'm willing to accept a low price. You could also say on the other end. Maker says, you know, I'm fine. You know, what Maker actually does is they only bring Oracle updates on chain with one hour delay. So the Oracle update comes on chain, but it can only be used for liquidation after one hour. So they actually say, hey, borrowers, we're going to give you a big fat warning.

Your position is underwater now, right now. And if you don't actually top it up within the hour, then we'll start liquidating you. But even then, they have this increasing price auction where they give the borrower even more time, right, basically to top it up. And sometimes transactions take or like that takes longer to liquidate in Maker. So Maker is a protocol that's very borrower-friendly. And then a protocol like Avio Compound is much more lender-friendly, I would say. And so you have these different sides of the spectrum. And it's really a design choice, you know, because they compete in the market.

And I think it's TBD, what works better and what's ultimately preferred by the market. Obviously, the only thing I'd add is there is a trade-off year, too, where in the maker design when you have that hour price delay and then the slower liquidation process, you need to have higher like collateral requirements because if you do have a kind of worst case scenario where a price is trending in a negative direction in the maker system, you need more of a buffer because it takes longer to perform liquidation. And so you need more higher collateral requirements are generally required there. And it also, the kind of maker design wouldn't work very well for higher volatility assets like shitcoins, right?

So there's this sort of tradeoff space that you're alluding to where you could run this slower kind of reverse touch auction to more, to bleed less money, but you, you know, can't support higher of all assets and you probably have higher collateral requirements there too. So big tradeoff space. Definitely. And so why do we care about, I guess, MV in general, right? So by the way, the connection that I would draw between MV and OEV is that MEV is basically money that privileged parties in any system can extract from other participants of that system to asymmetry of power or information. And it comes always from a conflict. between different preferences, two people wanting the same thing and then basically bidding to that centralized party in order to get that preference ultimately.

And so in the context of MEV, that's the validator, right? So if two people want to make the same trade, then the two people compete on the fee that they pay to the validator and hence bid up the price and so the money goes to validate us. And so how does it, how does it fit in the context of an Oracle update? So when the Oracle transaction actually goes on chain, then the liquidations basically become unlocked, right? And the transaction that's immediately following that Oracle update, then is the one that can capture that slippage limit, that slippage tolerance in value effectively. The difference between that and kind of the price at which they can internalize that trade. And when you kind of let that uncheck this ability for validate us to really like extract

different amounts of value from their blocks, then what you end up with is basically possible centralization spiral in the system. And for some systems, that's okay. In many cases, we saw actually MEV through centralization in like many real world systems. But in crypto, that's explicitly not what we want, right? We want to have this really decentralized base layer because that's like the validator layer is the root of trust in Ethereum. And we want Ethereum to become the root of trust in the global kind of financial and economic system in the future. And so that's why we put so much emphasis on keeping that validator layer decentralized.

And yeah, the company that I work for FlashBots and many others, I would say have done a lot in order to in the first step keep the validator layer decentralized by making kind of the same value blocks available to all the validators to techniques like MEV boost. And I mean, but what we're seeing right now is for example that a lot of decentralization is basically accumulating at the block building layer.

So right now there's one block builder that's building, I think 70% of blocks. And this is also something that we predicted because there's a lot of kind of network effect and scale economies and kind of get richer effects in in MEV and in block building. And so if you look at the block building layer now and you say, wow, it's looking very centralized. And this is effectively what was prevented on the validator layer by introducing systems like MEV boost. But in the block building layer, it's kind of more isolated and compartmentalized, and we are kind of, it's more solvable in some ways.

Right. Yeah, this has been my understanding since we did our endgame episode with Vitalik, where centralization in the block building layer has more optionality and checks upon the block builders than we do with validators. Once centralization happens at the validator level, it's kind of a one-way street. Kind of hard to come back from that, but with centralization in the block building layer, there's a lot of checks and balances. like Proposer Builder separation is one of these things.

I kind of want to zoom all the way back out and talk about like the highest level pattern that I see happening here, especially once we extend Defi to becoming, you know, the global financial system. You know, that's why I'm here in crypto. That's why many of us are here in crypto. And so say these markets aren't growing just by like 10x or 100x, but like are like 1,000x bigger. Like, and we have applications like AVE, like compound, like maker, becoming some of the foundations of borrowing and lending for the entire globe. This is this Oracle extractable value in his current form without a solution here. It would be a transfer of value from these applications and from the users and customers of these applications towards the infra level.

So it's like the infra level taxing the application level. applications are leaking value to the infra. And Haza, I think, something that you kind of alluded to is like, when you do that, you're kind of pressing the gas on the centralization of the infra level. And so with higher level solutions, which I think we're about to get into with what is being built here at Oval, with higher level solutions,

applications can actually stop leaking value and start retaining more of their value. And then the infra level is a little bit just more like streamlined. It's just like smoother because, there's less just like random volatility of like 100-Eth MEV blocks being going on. And everything's a little bit more stable and dependable. This is my understanding of the highest level patterns. Does that vibe? Does that check out?

Anything you want to add there? Yeah, it totally checks out. And I think where you're going with this, David, is like on this more of like the business side, the business strategy side or like application revenue side. So Hossu's perspective, you know, he wants to take. kill MEV because he worries about the centralization risks it creates, which I completely agree with. But I think there's another interesting byproduct here where if you can harness MEV within your application, you can use it as a revenue stream to do useful things. And I'm of the

opinion that just the way this all works, applications will leak MEV. There's ways to design them so they leak less, but eliminating it is going to be impossible. So if we, you know, being big picture here, design tools, order flow auctions that we're going to get into, if we can design tools to capture that MEV, we can not only decrease the centralization risks that Hossi was referring to, but we can also use that revenue stream to build business models and do useful things. And I guess the analogy here, and it's a little bit dangerous because I think people, some people have controversial views in Tradfut. on payment for order flow. But if you think what Robin Hood has done in the stock market is it used to be that brokers would have this order flow and kind of throw it out there for high-frequency trading firms to use.

And they were effectively like leaking revenue that those high-frequency trading firms were capturing. And Robin Hood, I don't exactly like all the ways they do this, but conceptually Robin Hood said, okay, actually, we're going to auction off this order flow and use that revenue to run our business so that we can offer free trading to users. And I think conceptually, if you think about D5 protocols doing similar things with maybe like better rules, more auditable rules, more transparency, you can actually get some pretty interesting business models where MEP Capture can drive sustainable long-term protocols that do useful things.

Yeah, I definitely agree with that. I would say we definitely don't only care about the decentralization of Ethereum. It's very important because without the decentralization of Ethereum, the whole experiment basically comes to stop. There's still a lot of the kind of gambling technology, right, that's built on top of it. But especially kind of the base layer of Ethereum is very important to, fight for. But that's sad. So I mean, FlashBots has a triple vision or a three part vision for a good reason. The first part is to illuminate the dark forest and can see this through, for example,

orderflow. Art, which is this really cool visualization of how your order, like any order is routed through the MEP supply chain, like who touches it, who exactly contributed to its eventual filling and like it getting on chain. And then democratize access to MEV, that's the second part. That's for validators, that they all basically get access to the same MEV. But the final part is distribute value back to users. And this is exactly where MEV share and over are coming in, because we have this vision that all MEVs should be returned to the parties who create it. Because, I mean, you can look at this from a few different angles.

So on the one hand, all of the applications are in competition with each other, of course, to, like, if they leave so much money on the table, that really belongs to their users and, or to them and they could like reinvest it in the business and make the experience better for users than applications that don't internalize their MEV will eventually, like to themselves or their users will eventually be outcompeted. But even more importantly, I think every, like when we look at these crazy numbers, how much money is lost to MEV every year, like billions of dollars, this is money that somebody lost, right, at the other end of it. So this is money that's straight coming out of the pocket of someone making like a swap on a decentralized exchange or someone providing liquidity or someone borrowing on a on a landing market and getting liquidated, right? So there's actually a real counterparty behind all of these.

And so if you want to build better systems, then we have to build systems that basically are robust to MEP in the sense that they expose less of it. But the ones that they still expose, they internalize it back to use us to employing techniques like MEP share and Oval. And I will add, as the industry of DFI has progress, it is a story of efficiencies and capital efficiency and like less leakage over this has just been the arc that defy is on.

Like this isn't something brand new. Just all applications are innovating on how to be more capital efficient, how to best serve their customers. And this is just like another milestone on that arc of evolution of defy. And with that as the context, maybe we can actually get into some of the specifics of the oval mechanism and how we are actually doing this, how we are actually. returning value or keeping value in the applications in user's hands and kind of like stopping, nipping some MEV in the bud is kind of maybe how I will frame it. And so Hart, I'll throw this one

to you. Can you just kind of explain the Oval mechanism and what it does? Yeah, absolutely. So oval is a mechanism for OEV capture or capturing this specific type of Oracle-created MEV. Oval's not an Oracle. It uses chain link or chain link price updates. But what it essentially does is say, hey, liquidators, searchers, if you want to use this chain link price update, if you want to be the first one to use it, you have to participate in an auction. And the winner of that auction gets the first right to use this chain link price update for a specific protocol. And so really all Oval's doing is saying chain link updates come in, let's run an auction on them. And we run an auction for each protocol.

So there's a different auction running for AVE or and for compound. And that's so that we can actually understand exactly how much OEV is created for AVE or for compound. And we use FlashBot's MevShare infrastructure to run this auction process and to actually guarantee or enforce that the searcher that paid the most in the auction, that their money actually gets returned back to the protocol. Seems like a relatively simple mechanism. This is an opt-in mechanism by lending applications like of a compound maker, for example. So these things need to elect to use Oval, correct?

Correct. You can think of this as like a bolt-on for chain link. So it like wraps a chain link price update. So right now, Avey and Compound and many, many other DFI protocols have an address where they're like, give me the ETH USD price feed from Chainlink. And what Oval does, it says, okay, we have a contract that looks like Chainlink, but only lets you use that chain link price update if you participated in this auction for a very short window. and after that short window is done, then it now looks exactly like Chainlink, it just passes through.

So it's kind of just a gate that enforces this OEV auction happens for a very short period of time before just defaulting back to ChainLink. So all Defy protocols have to do is swap a single address via governance to kind of bolt on this oval intermediary and begin extracting OEV.

So it's like an auction module that's being appended on to the the Oracle price updates that ChainLink is providing defy. And how this makes sense as to how you brought up the Robin Hood analogy, where, you know, at one phase in Robin Hood's life, they were just casting off their user's order flow into the wild and then suffering worse execution for their customers because whoever could do the high frequency trading would get there first. And instead, they opted in for an auction mechanism instead in lieu of that.

So it's like this little like waiting room before the free market happens for auction to discover the price before their users were able to actually like get the better price and they would get a better price as a result. And in this analogy, Aves are the users, compound as the users, MakerDAO as the users. And instead of just having access to their liquidations being free for any and all MEV bots that come first and execute it suboptimally, instead there is a short window of time for market price to be discovered, fair price to be discovered. And then that value is retained by the lending application. Is this correct? Yeah, exactly right. So that analogy totally holds. And if we go back to the kind of slippage analogy where we're saying,

hey, this liquidation is going to have a fixed 10% liquidation bonus. We're going to run an auction that says, okay, what does it actually cost? What will people pay here? And people say, okay, I'll actually only pay, I'll buy this collateral for a 1% discount and 90% gets captured and rooted back to the protocol. So we are using the auction to create the market clearing price for the right price to perform the liquidation in these lending markets. So this solves the problem of some of these lending markets not knowing, not knowing what the fair price of their collateral is, whether it's a large supply of ether or a supply of shit coins. They don't know the governance.

parameters around collateral in Ave compound maker, etc. They don't know what the market price is. So they have to basically give themselves worst execution in order to protect themselves. And so this is like a best execution module appended on to their liquidations, which ultimately flows back into the collateral that's liquidated at a better price from their customers, correct? Yeah, I like this best execution module. I'm going to use that.

We make a high end up bankless. Hossu said it really well. You go back and you think about on Uniswap, I'm wanting to buy a shit coin. Price is all over the place. So I set a wide slippage limit just to guarantee I get a fill. Or I set it tight to keep the price, more price guarantee. I don't know. So lending protocols are in the same scenario.

They really need to sell this collateral, but they don't know how cheap they need to sell it. And so by running an auction and going through this order flow auction for the right to perform this liquidation, we're able to use market forces and competition to precisely set that liquidation bonus to the market clearing price. I have some follow on thoughts to that. So this is one of my favorite topics for years. And it's very hard to like nerds and my people on it. So now is my time. Okay. So give me like my few minutes.

But so both you actually, so we talk about. oracles, which is funny, because like both setting your fee, how much gray you basically want to want a bit per gas, and how much slippage you want to set, those are both Oracle problems in themselves. So they are both problems that are basically, you as a user, you have no idea what you should, you should put, and they are very hard to parameterize. And so in the example of a, of a regular transaction, right? This is the fee estimation problem and for regular transfer, this is not too hard to say because you can just look at, okay, what's like the lowest fee that's the gut into the last block basically. And you use that as your oracle. Okay. So, and then you parameterize your trade like

that. But once there's basically contest between different preferences over the same state, so for example, in multiple people trading in the same unisop pool and somebody like the one person's trade might make another person's trade invalid because it's now beyond their slippage tolerance, right? Now all of a sudden, parameterizing your transaction fee is a very difficult problem. And so it basically spills over into the slippage tolerance. The slippage tolerance is basically an extension of the transaction fee. And I mean, what happens here is that you have no idea like how much you're paying for your transaction right now.

So it's basically is your fee plus your slippage. Like you can basically add those. and they become in any kind of dextrate, they become your actual transaction fee that you're willing to pay. But you don't know even how much you're actually bidding because that depends on like other parties in the block as well. And so this is where an order flow auction comes in

that runs basically at block building, at block building speed as well. Because what it really does, it gives you this oracle for how much you should bid in order to get into the block. And so, yeah, that's the connection between, that's the connection basically between OFAs. Like, they reveal what is the correct fee to set across all of your parameters. It's like the transaction fee and the slippage tolerance together.

And then they get you into the block at the cheapest possible price when they work, when they have like enough bidding taking place. Yeah. Well, to keep going on this, right? So the nerd sniping of it, the liquidators in this system are off-chain actors. that have full visibility into all these costs and fees. And then through forces of competition, they're figuring out who's going to serve you the best price. So we're able to utilize off-chain actors to know things that the protocol itself doesn't know at that moment in time.

And I think that's pretty cool. The off-chain actors, they're just the market. And the market knows a lot. The market is the aggregate of all information. So it's a place where just like the aggregate knowledge of the market can actually become to be expressed and then leveraged by the defy applications. Yeah, exactly. And, you know, what we're talking of primarization, there's interesting knock-on effects here too. So lending markets like Ave, they can't easily onboard like shit coin collateral because the price moves too much or whatever.

it could create bad debt for the system. But you could imagine where they onboard shit coin collateral with like a potential 40% liquidation bonus, like something really big that if you had to pay that every time, it would be incredibly painful. But you can now do it safely because you have a huge potential bonus, but you have market forces that actually means you're never going to pay that. You're going to pay the market clearing price. And so we've inserted a new tool that gives us real-time, information to parameterize some of the important parameters within a lending market like AVE, and we can use that tool to actually like onboard new collateral and kind of add new features.

Right. So the net effect of this is that blue chip collateral in systems like AVE compound maker, Ether will probably be able to achieve even better collateral factors. It will be even more efficient to use ether. And this will be true for all the collateral that's currently in there. There's more efficiency, more capital efficiency for all capital assets. And then also the hurdle, the requirement for actually being onboarded into AVE gets easier. So we can actually extend the long tail into further, less liquid collaterals simply because we have better market clearing mechanisms in order to enable these things. Which is to the net effect of AVE, just like an increased revenue for the application and increased a better product for its customers. Yeah, they have a useful new tool in their toolbox to make AVE more efficient and support more collateral types.

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Maybe you can kind of go into the specifics of like, if you pop open the hood of this system, what does it look like in the background? Like, how does this thing work? MEV share? Yeah, the part of MEV share that Oval taps into. Yeah, so MEV share is what I would say, what I would call an order flow auction protocol.

So it's, it consists, it introduces one new party that we don't typically talk about. And it's called the MEV share node. And it has, why is it a protocol? Because it allows basically for OFAs or like applications to be built on top by wallets, by applications like over that then kind of extend the service to the landing markets. And it's very customizable. So you can basically customize it across two different dimensions. one is the privacy.

So a lot of in MEP, it's a lot about privacy, right? Since we said it's about basically value that can be extracted by having, you know, some kind of asymmetry of information. So how much information you reveal and who you reveal it to is a very big lever in MUV.

And so in MEP share, you can customize exactly which parts of your transactions are revealed to the bidders, who are the searchers. And there's a kind of general tradeoff here where if you reveal too much, then you can be front run off chain. For example, you know, you reveal your intent to trade a certain asset, but then somebody just buys up the asset kind of outside and just they sandwich you basically outside of the auction, right? But when you reveal nothing, then you leave a lot of guesswork to the searchers basically to guess what your intent is and they may not be very close in their guess. And so you want to find the exact sweet spot between like revealing some details, but not so much that you can be front-front. And it really depends on the exact application and asset that we're talking about.

And this is why we leave this choice to the applications that build on top of the. protocol. And the second is the for any surplus value that's created. So for the money that's, that's coming in from the bidders, how is that distributed? And so this is also the choice of oval. So between the, you know, oval and the landing market and the block builder and like any other party that they want to specify, who do they want to send the value to that's being created? So that also affects kind of the dynamics of the auction. And so, yeah, you can basically create an order flow auction. You can parameterize it kind of across these dimensions.

And then what happens is in a very simple flow. So like a transaction comes into the MEV node. And then the MEV node selectively reveals information to search us that they can, that they can access. And any searcher can access this because it's permissionless. And then the searchers basically sent back their bits, and very often they will be kind of guessing based because they cannot actually see the full intent of the transaction. They can only, for example, see, okay, this is like a certain UNICEP pool. So is this like EFUSDC or something, but they don't know whether the person is buying or selling or how much.

And so what they basically do, what is the right strategy for searches is to submit not just one, trade intent, but submit basically like a whole order book, if you would. So they would basically submit, okay, if they want to buy this much, here's what I would, here's what I would want. If they buy like this much, here's what I would want. If they want to sell, here's my bit. And if they want to sell more, here's my bit. Right.

So every search that submits basically their own order book. And then inside the MEV note, you have what is basically a matching engine, you know, same as on an exchange. So you have now all of the order books. from all of the searches laid on top of each other. And you have the one, so these are all of the bits. And then you have to ask from the user. And you just match basically the most, the best bit against the users ask.

You grab them into a bundle and you forward it to block builders. And then it goes into the block and kind of the value. Like part of that bundle is also the redistribution of the value, like who it goes to. And so that's being forwarded to the build. and I think like the top X bundles are forwarded, and then the builder can still choose which ones they take, but usually they take the one that pays them the most, right? And so, yeah, very roughly speaking, that's how it works.

The pattern that I'm seeing here, I'm just going to go back to my line from earlier, is that the cool thing about MEV is that we once thought it was this massive problem. And one of the patterns that I've seen over time is actually mechanisms are allowing us to leverage this problem into market clearing forces. And Haza, when you tell me that like each individual searcher will dump an entire order

book into this node, to me, that's like saying one of these many thousands of searchers out there are taking their entire view on the market, placing that into a codified order book, depositing this order book into a central clearing entity, which is this node that you're talking about in MEV share, these orders get matched up, everything clears. and all of a sudden we have market clearing forces happening in a very short amount of time very, very quickly. And so what was once this very toxic centralizing system that was liquiding people at suboptimal prices

and was creating centralization forces in our infrastructure has instead resulted in just super efficient markets, which has always kind of been like the sci-fi vision for defy, I think. Yeah. Cool. So, Hazer, when we talk about one node, maybe more nodes, a few nodes, collecting all of the market information sounds centralized. Is there like a decentralization of MebShare conversation or of the infra that makes this whole system happen? What's this look like?

Yeah, for sure. So you're absolutely right. The MEV share node is a new centralized actor in the system. So I think in this case, it's not a problem because the search. It doesn't introduce any new trust assumptions in the sense that FlashBels is already a block builder and a relay. And so effectively, everybody already trusts us with all of this information. So for us in particular, it doesn't add any trust assumptions. But nonetheless, I mean, we want to decentralize all of our products.

So from builder, relay, maybe share. And that's, that is the vision behind Swarv. And so you did this really great application. saw it with Phil, Deyan and Andrew Miller, where you dove into this. And for anyone who hasn't seen it, I would strongly recommend it because it's such a great intro. But the gist is, I would say that Suave is a platform that enables new primitives, in particular, the ability to write private smart contracts and have credible off-chain computation. And so, for example, when you look at an order flow auction, you see, hey, these are exactly like two things that it uses, right? It uses privacy, but it solves it basically through centralization.

So we just send it to a centralized server and we hope that the server doesn't leak the information or like not more of the than the information that it's supposed to leak. And while it's also, it's running off chain and nobody can validate that the like we are, we say that, you know, the MV share note runs a certain code. And it's open source on our GitHub, right? But do you actually know that this is what we're running? No, you don't, right? And so one of the beautiful things about Ethereum is anybody can see the code behind a smart contract and know that this is exactly what the virtual machine executes, right? And so this is basically what Swarth does.

It introduces a new virtual machine that can do private computation and has private storage for private data. but you can also write code as smart contracts that could otherwise only execute on an off-chain server. When you put those things together, the off-chain, the credible off-chain computation and the decentralized privacy, then you get access, like you unlock a whole new part of kind of the tech tree for crypto and MEV in particular. And so where we eventually want to go with this is decentralized block building. So we want kind of the whole auction like intense coming in from users and like the whole shebang about how that's basically turned into a block and eventually executed on chain.

We want to decentralize the whole of that. But for something like MEV shared, this is actually really easy to see how it's one of the first things that benefits from SWAF because all you do is like you run the same code. but you run it instead of on our centralized server, you run it on SWARF. And all of a sudden, you no longer need to trust flashboards as an centralized party to run the code that we say

and to keep your information private because now you basically delegate all of that trust to a decentralized network. So if listeners are curious into going down that rabbit hole, Hauser just pointed to the bankless episode about SWV that we did. I don't think it would be a mistake to rehash all of that here, but I think this is where that part of the conversation leads.

Hart, go for it. Yeah, no, no, to add to that, first of all, that episode is really, really good. And I do think of, like Hasew said, Mevshare is a protocol for building, for order flow auctions with some points of centralization. I look at suave. Swab is a lot more than that, but I look at suave as going to be a decentralized protocol for order flow auctions, and I'm actually really excited about it. The one other point I want to make on the Oval side, the way we've architected this, the trust assumptions Oval introduces, I think are just pretty brilliant because the way it works is the absolute worst thing if like Meveshare had rogue code that was stealing the mev or Oval decided to send the mev to a different address or anything like that.

the worst case from a lending protocols perspective is that they don't get the MEV that they weren't otherwise getting. So it's like, you're just back to you started. The worst case is table stakes. The worst case is table stakes. And the other answer here, just because there have been some questions around centralization concerns in the Oval Design, even if the Mevshare node goes down or the oval node goes down, that infrastructure all breaks, as soon as this short auction,

passes, the Oval contract on chain on Ethereum just passes through and lets you read chain link prices. So it can't censor chain link prices. It can't prevent liquidations. It really is like worst case is table stakes to what lending protocols have now. All you're doing is inserting this short auction that if it were to go rogue would steal the money you didn't get before. So it's like a really elegant bolt-on, you know, best execution module, as you put it. That doesn't, it does have a point of centralization, but the fallback is super elegant. You're just back to where you started. You talk about this short auction.

How long is it? It's a parameter of the protocol. They can set it to what they want. And this gets a little bit technical in terms of like why would it be more than one block. And the answer is not every block builder or not every block builder is connected to MebShare. And so you don't necessarily have complete coverage on every slot. So you could have basically by our math and Hossu will know this better. You have like 90% of blocks are mined by builders connected to Mebshare. So if you don't have your, if your auction happens to land in a block that is

not mined or built by MFshare, a validator picks a block that's not coming from Mepshare. You might not capture your OEV, but yeah, it gets a little more technical. Otherwise, it's one block. It's supposed to be one block. Yeah, 90% of the time, you're going to happen the same price update or the same block that the chain link update would get mined if you didn't use Oval. Yeah. And the nice thing about MEP shares that it doesn't actually increase the latency of transactions

that go on chain because it runs during the one block window. And yeah, so as Hart was saying, in the positive, like the normal case, you don't incur any additional penalties. So this is really more of a fail-safe mechanism, right? So just in case kind of either of the two notes is offline, then you want to have some kind of fallback so that the transaction can still go on chain. Cool. Cool.

understood. So Hart, I think this kind of brings us to the last bit of conversation, which we looked at the technical conversation under the hood, the economic conversation as to the incentives, as to why protocols will adopt this. But I think now we have to get into the BD conversation, because ultimately things don't move unless humans like shake hands over telegram or in discords or whatever. And so you actually need protocols to adopt this system. How's that going? Going well. We put up a proposal. up to AVEA to adopt Oval in a very, very limited way. So one of the advantages of AVE, their standard markets are all interlinked,

and they want to be very, very cautious of changing anything because there's billions of dollars at risk. But they also have AVE V3 isolated markets, which are siloed and separated from the rest of the system. So we made a proposal to integrate Oval into AVEV3 markets that have about $10 million in total TVL, which is 0.1% of the total AVE TVL. And it's a pretty cool way for AVE to experiment with OEV capture in a very safe, low-risk way and get comfortable, get familiar with it, and potentially roll it out to the broader protocol.

Where I think, again, if it rolled out to the broader protocol, I think AVE would be more than doubling their revenue. they'd be earning another 25 million bucks a year type thing. Same with compound. And then, of course, there's all these other, we talk about Avey a lot on this podcast just because it's a good example. But there's all these other defy protocols

that we're really excited that are using chainling price updates that are leaking MEV. And we have this really easy integration that we've been chatting with and really excited to integrate. Interesting. I want to actually go down a side quest that's parallel to this, I think. HaZo, I think you might be familiar with this.

Maybe both of you are. Sorrella Labs and their Uniswap V4 hook. Maybe I can set this up in, Hasey, you can take the rest of it. It's a very similar mechanism, although it's not at all to do with Oracle extractable value, but it has to do with impermanent loss in uniswap, which is now being, I think, rebranded to LVR, which is an equally bad name, but whatever. And so, like, you know, Uniswap LPs are getting squeezed by sex, dex arbitrage. So when, like, Binance updates its price, that eventually turns into MEV on dexes.

And then Uniswap LPs are just having this arbitraged out. And something that Ludwig at Sorolla Labs is building is this hook on Uniswap v4, which is kind of just like oval, a gate for liquidity. and if you want to access the liquidity in Uniswap v4 that liquidity providers have deposited through this gate, then you have to operate by the rules of this gate and the rules of this gate do something very, very similar to what Hart was talking about here at Oval. Maybe you can talk about just like how this works

with a little bit more clarity than what I just gave, but also talk about the pattern and how we're seeing this kind of being extrapolated into different contexts. Yeah, so you're, you're exactly right. So it's the exact same pattern and I think the pattern is what's most interesting to understand. So if we kind of go back to what we said earlier, so user wants to trade a token, they don't know what feed is said. They don't know what slippage tolerance to

set. So you kind of have this oracle problem, like how much to bid basically to the valid data and you don't even know how much you're bidding. And so the very same problem, the LPs also have. because so they have a price and maybe the price is kind of the market price but then 12 seconds pass and now all of a sudden they're still quoting that price from 12 seconds ago, right? Because it's an AMM,

the price didn't move unless someone trades against it. Or they kind of updated manually, right? But they, so they are quoting this outdated price and now somebody can trade against them and whether it's an Oracle or whether it's a liquidity pool. or the user making a dextrate, if you're, if you're accepting a certain price, then, and somebody else can see that intent, then they will always push you to the worst possible price. And so that's what happens in arbitrage. And I mean, arbitrage, like the LVR problem

is, is a problem that's like 20 times bigger than, than even the Oracle problem. So this is like a huge, a huge problem, I would say. And yeah, so the, but the very same insight that Oval users can be exactly applied also to liquidity pools. So you basically put, like, as you were calling it, you kind of have two ways of doing it. One, you put a gate and it basically says in order to earn the right to trade on this pool, oval style, you have to pay me. And so we run an auction. And so you basically unlock the right to do this.

The other way is to basically the pool, there's also an auction, but instead of running the right to trade, it like increases, basically. basically the transaction fee to the fee that goes to the LPs in the pool. So it makes that variable. And so when it knows that there's like a large, basically, demand to trade in the pool, then it would increase the, it would increase the fee to capture more of the MUV back to the LPs who are in the pool. So I'm not familiar which model exactly. So while I use it, if they found a third way.

But yeah, I think the inside is basically to use some kind of mechanism, some kind of auction that discovers basically the price at which the LPs should quote to the market. And I'm going to go ahead and hard to say something. No, I just think this is the role solution. It is using the gating mechanism. I mean, again, we should have led to look and all them talk. But it is a very cool, elegant solution that says, hey, we know there's like sex, sex arbitrage that's getting leaked here.

So you just, if you want to trade against this pool, you got to pay us. and that goes back to the LPs. So I'm really excited for that to get deployed too. So one last conversation here. So we have Oval and this gate. We have this pattern that we were seeing applied on to Uniswap with V4 with the project that we just brought up, Srella Labs. But each of these are taking a cut, right?

Because, come on, like we are rational economic actors. We want our upside. I'm assuming there's a cut that's part of the whole Oval process Is that correct, Hart? Yeah, there is. I mean, I think it makes a lot of sense. Like Hossu said at the beginning, MEP should go back to the protocol that created it or the source that created it. And we very much believe that.

So this MEV that we're capturing should go back to AVE or compound. And they can mostly go back to Avey and compound. And they can use it to say, hey, we're going to keep it for revenue for the protocol. We're going to get back to token holders. we're going to reimburse the guy that got liquidated. We're going to make transaction costs free. We're going to pay every his gas costs. Whatever they want to do.

That's their call. And then I think the infrastructure that extracts that MEV also deserves a fair share for the work of building and maintaining the infrastructure to do so. And so that's the business model for Oval, where we would retain our share for the infrastructure cost. And the other thing I'd add is there's other infrastructure costs besides us. There's flashbots, Mepshare, suave in the future. And importantly, in the case of Oracle updates, there's also like ChainLink or your Oracle provider.

And one of the things I'm excited about is using this as a sustainable way to pay for Oracle infrastructure as well because it's not cheap. not cheap. Chainlink is spending millions of dollars a year and gas fees supporting their price feeds as a sort of public service. And this, this is something that long run is actually a risk to AVE and compound because like it's not currently sustainable. Chain link can get paid. Avey compound maker, maybe not maker, are consuming chain link oracle prices. And chain link is just giving this out to the defy for free. I'm assuming they make money on that. somehow. Maybe not? That's complicated. That's a good question to ask chain link.

But the price feeds are permissionless. Anyone can access these price feeds for free. So chain link itself or, and you know, insert your generalized Oracle provider here, also needs to be a part of this process of achieving some sort of take rate in order to make themselves a sustainable business, otherwise they go away. Yeah, I agree. And like, again, chain link has many different kind of have products and business lines and they do charge or have fees in other circumstances. But the core product that supports most of Defi, like their ETHUSD price feed, it's freely accessible

and Defi is built on top of it. And figuring out a way to make that be sustainable seems like seems necessary. Right. Totally. Totally. Ha'u, I have learned a ton in this conversation. Is there any stone left unturned or maybe just future questions that you have or future topics that I think that you guys might think are next in this conversation. Maybe if we were to resume this conversation in like a year or so, maybe what are some ideas that you would hope would have answers or any future conversations that you think spawns out of this one? Hazu, I'll start with you. I need to think about this. Can Hart go first? Well, I'll give you an easy one. I mean, how does this work on layer two's? Like, what does the MEV supply chain on layer two's look

like what are the types, what's the type of like Oracle or Oracle related MEV that gets leaked on layer twos? And there's actually a whole slew of MEV that gets leaked by perpetual exchanges, like perp exchanges, decentralized perps, and ways that I think they could be made much more efficient by using auction-like structures to price their trades. So that's where my mind goes. We've actually done a lot of work and a lot of research on how Oval would work on L2s. And I'm not enough for this podcast, but I think it's a super fascinating topic. And I think it's going to be a big deal. Yeah, I agree with that.

I think if we come back in one year, I would be very interested to kind of just do a checkup on how much MV is still being leaked at the application layer. How much basically extra money is leaked by landing protocols, but also we talked about IPs, right. So for me, that would be interesting if that paradigm that with the gate basically unlocking kind of certain actions on chain through an auction, if that's taking hold also in the deck space. And then for sure, as hard was saying, as more and more activity goes to layer two, so how can we how can we import some of that same paradigm basically to the layer twos? the layer two is today all have centralized sequencers and they don't have much of an MEV supply chain to speak of.

So they all have a kind of shadow MEV supply chain that's kind of, you know, like co-located around the sequencer, like, but like in an kind of uncontrolled way that doesn't benefit the users at all. It doesn't even return any money to the sequencer. Nor can really be leveraged to build any kind of applications on top. like order flow auctions yet. So I would say there's some kind of ground infrastructure that needs to be created.

And then I think a lot of this technology can be scaled to layer twos. And it will be very interesting to see if it looks the same or if it looks different and if it looks different, like in what ways. Beautiful guys. I think we have a long roadmap of content ahead of us. There's a lot of juice left to squeeze out of these conversations.

A lot of juice left to keep in the defy apps. Hart, Hazu, thank you so much for coming on and explaining this part of the DeFi world to us. Thanks, David. Thanks, David. Thanks for having us. Hart, if people are just interested in learning more about Oval, where should they go? Yeah, so Oval is an UMA product. Go to Uma.X, XYZ, and you can read all about it.

And then Twitter, it's at UMA Protocol. Yeah. Guys, this has been fantastic. Thank you so much for coming on. Bankless Nation, you know the deal. Crypto is risky, DFI is risky. Hopefully, it's becoming a little bit less risky. But you could still lose what you put in.

We are headed west. This is the frontier. It's not for everyone, but we're glad you are with us on the bankless journey. Thanks a lot.