Credible Decentralized Exchange Design via Verifiable Sequencing Rules (2209.15569v2)

Abstract: Trading on decentralized exchanges has been one of the primary use cases for permissionless blockchains with daily trading volume exceeding billions of U.S.~dollars. In the status quo, users broadcast transactions and miners are responsible for composing a block of transactions and picking an execution ordering -- the order in which transactions execute in the exchange. Due to the lack of a regulatory framework, it is common to observe miners exploiting their privileged position by front-running transactions and obtaining risk-fee profits. In this work, we propose to modify the interaction between miners and users and initiate the study of {\em verifiable sequencing rules}. As in the status quo, miners can determine the content of a block; however, they commit to respecting a sequencing rule that constrains the execution ordering and is verifiable (there is a polynomial time algorithm that can verify if the execution ordering satisfies such constraints). Thus in the event a miner deviates from the sequencing rule, anyone can generate a proof of non-compliance. We ask if there are sequencing rules that limit price manipulation from miners in a two-token liquidity pool exchange. Our first result is an impossibility theorem: for any sequencing rule, there is an instance of user transactions where the miner can obtain non-zero risk-free profits. In light of this impossibility result, our main result is a verifiable sequencing rule that provides execution price guarantees for users. In particular, for any user transaction A, it ensures that either (1) the execution price of A is at least as good as if A was the only transaction in the block, or (2) the execution price of A is worse than this ``standalone'' price and the miner does not gain (or lose) when including A in the block.

• The paper presents a novel sequencing rule that mitigates miner manipulations like MEV and sandwich attacks in decentralized exchanges.
• It details algorithmic solutions that enforce verifiable transaction ordering to maintain fair execution prices for users.
• The research provides theoretical insights and acknowledges limitations, laying groundwork for future improvements in DeFi protocols.

Decentralized Finance and Sequencing Rules in Liquidity Pool Exchanges

This paper provides an in-depth analysis of decentralized finance (DeFi) protocols, focusing particularly on liquidity pool exchanges like Uniswap. Key issues addressed are the risks of miner manipulations in decentralized exchanges, notably through Miner Extractable Value (MEV) and front-running attacks such as sandwich attacks. The authors explore algorithmic solutions to mitigate these vulnerabilities and propose a novel sequencing framework.

Decentralized Exchanges and Miner Manipulation

DeFi platforms are built on permissionless blockchains and enable liquidity providers to earn revenue via locked capital in smart contracts. The paper highlights the scalability and operational benefits of decentralized exchanges over traditional order books, particularly in blockchain environments where computational and storage resources are scarce. Liquidity pool exchanges offer advantage in terms of constant memory usage and instantaneous order execution.

However, miners, or block proposers, exploit their role by influencing execution orderings, thus enabling MEV through front-running attacks. The paper describes the sandwich attack as a prominent method, whereby miners manipulate transaction placement to gain risk-free profits at the expense of users, and address the lack of regulatory oversight in decentralized exchanges.

Mitigating Miner Manipulation: Proposed Approaches

The authors argue for relay services and sequencing rules as potential solutions to counteract miner manipulations. A trusted relay service allows users to submit transactions that are then handled by a trusted set of miners. However, the credibility of such services is questioned due to the absence of a verification mechanism.

The paper introduces verifiable sequencing rules aimed at maintaining fairness without compromising efficiency. These rules are defined such that the order of transaction execution is verifiable and deviations can be punished. Particularly, the proposed Greedy Sequencing Rule ensures users achieve execution prices at least as favorable as standalone prices and restricts miner profits from inserting self-serving transactions.

Theoretical Insight and Results

The authors present several notable theoretical findings:

1. Arbitrary Execution Prices: Theorem~1 illustrates that miners can manipulate execution prices arbitrarily in the absence of effective sequencing rules.
2. Impossibility of Perfect Protections: Theorem~2 emphasizes the inherent limitations of any sequencing rule owing to examples where miners can always find undetectable profitable deviations in certain conditions.
3. Greedy Sequencing Rule: Theorem~3 proposes a sequencing rule ensuring that any user transaction is executed at fair prices unless the miner deviates detectably, or such deviation yields no advantage to the miner.

These results underscore the potential of sequencing rules to provide verifiable guarantees while acknowledging inherent limitations.

Implications and Future Directions

This research contributes to enhancing the stability and fairness of decentralized exchanges by addressing MEV and front-running attacks. The Greedy Sequencing Rule provides a promising path toward reducing miner manipulation in decentralized settings, although it cannot entirely eliminate all risks.

In a broader context, this work emphasizes the need for continuous innovation in algorithmic governance and trust mechanisms, lying at the intersection between computational efficiency and economic incentives. Future advancements may focus on refining sequencing rules and integrating regulatory frameworks more effectively in the DeFi ecosystem.

Conclusion

The paper provides a comprehensive exploration of liquidity pool exchanges, their vulnerabilities to miner manipulation, and algorithmic strategies to mitigate these issues. By proposing credible sequencing methodologies, it sets an academic foundation that supports both the theoretical and practical advancement of decentralized market infrastructures, offering new directions for research and implementation in the ever-evolving field of decentralized finance.