Prop 421: ProtoRev Revenue Allocation

This proposal indicates that the revenue captured by the ProtoRev module will be allowed to accumulate within a module address until at least the 1st June 2023
This time will be used to gather data on the revenue accumulated and discuss ideas on how best to utilise it. After one month of reviewing proposals for recommended options, the community should make a decision on the direction of the ProtoRev account.

# Purpose

The purpose of this proposal is to provide a recommendation around how Osmosis should initially handle the revenue generated by the ProtoRev module.

Once the ProtoRev module is implemented as part of the v15 upgrade, the community will need to decide how this revenue should be allocated. We recommend that Osmosis wait a minimum of 4 months and let the revenue accrue to a dedicated account controlled by governance. While it should be deployed to the benefit of Osmosis in the future, the community should wait until it has accumulated enough capital to make a material impact whenever it is deployed.

# Background

## ProtoRev Module Design Overview

As described in the governance forum post about the ProtoRev module, the module will check a set of possible arbitrage routes after every transaction and determine whether a back-running arbitrage opportunity was created by the transaction. The module will then:
* Determine the most profitable arbitrage opportunity and optimal trade size
* Leverage the Bank module to flash-loan itself the tokens required to perform the arbitrage trade
* Conduct the swaps for guaranteed profit
* Repay the loan by burning the flash-loaned assets

These transactions will take place after standard user transactions at the end of the block to rebalance the pools and capture the arbitrage profits. The revenue captured by the ProtoRev module will accrue to an account controlled by Osmosis governance. The ProtoRev module will conduct OSMO and ATOM settled arbs initially, so this account will hold a mix of OSMO and ATOM.

## Benefits for Osmosis

The ProtoRev module is a groundbreaking innovation for AMMs and stands to improve the economic sustainability and UX for Osmosis:

Economic Sustainability
The ability to capture in-protocol MEV as protocol revenue is one of the largest competitive advantages that Osmosis has over DEX’s built on monolithic chains. These other AMM applications are limited to rent-seeking forms of revenue generation (e.g. Uniswap’s fee switch) because all MEV accrues directly to validators. That’s not to say that Osmosis should not implement a take rate on trading fees, but rather that it’s unlikely to be sustainable as the only form of protocol revenue.

We have already begun to see compression of DEX fees as evidenced by the introduction of Uniswap’s 5bps and 1bp fee tiers. We have also seen this dynamic play out with traditional exchanges, as Robinhood was able to capture huge amounts of market share from incumbents (e.g. Fidelity, Schwab) by removing trading fees. As more DEXs enter the Cosmos ecosystem, the ability to undercut fees will serve as a strong competitor differentiator for Osmosis. By allowing Osmosis to capture a more sustainable revenue stream in the form of benign MEV, the ProtoRev module greatly improves Osmosis’s positioning as the space becomes more competitive.

Protocol Health
In addition to capturing protocol revenue that would otherwise be lost to searchers, the ProtoRev module will also improve the UX of Osmosis. Current arbitrage systems run intermittently, allowing price differentials to remain in place for multiple blocks. The ProtoRev module will keep asset prices even across pools for every trade by running cyclical arbitrage at the end of each block to rebalance the pools.

# Revenue Projections

From October 1 to December 31st, there has been $176,637.97 extracted from Osmosis liquidity pools in the form of arbitrage transactions. This translates to approximately $1,941 per day. (Source)

As can be seen from the below charts from this period, this extraction varies hugely depending on the market conditions which trigger these transactions during periods of high volatility.
$30,737 (17.6%) of this MEV was extracted over the two days of October 27th, 2022 to October 28th 2022 (Binance Listing)

The FTX collapse caused significantly higher volatility and so higher MEV extraction during the second week of November 2022.

December 10th 2022 has a spike in price caused by manipulation on Binance due to closed withdrawals/deposits. (Source)

USD Captured as MEV on Osmosis 3rd October 2022 - 31st December 2022

Price and Volume chart of OSMO in the same period, showing alignment of volatile periods with increase in MEV.

During a stable bear market, excluding these spikes, we may expect MEV to reach $1,368 per day, of which an estimated 70-80% will be recovered by the ProtoRev module.

For comparison purposes, during the last bull market, for February 1st 2022 - April 31st 2021, cumulative MEV collected was $1,821,199, or $20,462 per day. This shows that the potential return from the ProtoRev module in arbitrage alone may be a significant part of protocol income in the future. Especially with the addition of links to many more chains since this period than existed on Osmosis at the time, allowing for more opportunities for arbitrage between routes to occur.

# Recommendation

As the bear market rages on, we want to ensure the MEV revenue generated by the ProtoRev module is utilized in a manner which maximizes its benefits to the Osmosis community. The Osmosis Community Pool at the time of this writing currently holds 63.22M OSMO tokens. This is expected to grow at an accelerated rate as we continue to shift incentives which were previously allocated to incentivizing liquidity pools.

To this end, MEV revenue should be deployed at times when the contributions can be meaningful in size to the protocol. As discussed, on average we may expect MEV to reach ~$1300 per day which we can expect the ProtoRev module to recover the majority of.

Although this creates a positive value accrual mechanism for the Osmosis community, the amounts being generated would not be significant if added to the community pool which currently is receiving 60% of the liquidity incentives. Allowing this revenue to be directed to the community pool would fail to maximize the benefits to the traders, liquidity providers and stakers of Osmosis.

In the current market conditions, directing this revenue to stakers would not move the needle in terms of value accrual to OSMO. By our estimates, stakers would only see a 0.8% increase in staking yield (e.g. 23.28% to 23.46%) if they were to receive 100% of the ProtoRev module’s revenue. Since Skip will receive 20% of the revenue in Year 1 (as part of the community approved payment schedule, stakers would only see 0.14% added to their APR. While the community should consider this option in the future as the emission schedule winds down, or if MEV revenue increases, there are likely more impactful ways to deploy this capital in the near term.

As such, we are proposing the revenue generated from MEV is collected, until the funds can grow to have a meaningful impact towards benefiting the community. We believe it is in the best interest of the community to collect the revenue in an account controlled by governance. Over the next four months, community members should submit proposals with their recommendation on how best to deploy these funds. The community can then vote on the potential options to distribute this revenue. We recommend that the community should conduct reviews on a quarterly basis to evaluate the ongoing impact of deployed capital. Based on the results, adjustments can be made as needed to ensure this protocol income is utilized effectively and proportionately.

Below are some ideas on how we could deploy MEV revenue in the future:

UX Benefits
* Subsidization of swap fees, gas fees, or bridge / on-ramping fees

Supplementing / Replacing Costs
* Supplement LP yield for high priority (e.g. Superfluid Staking) or under-incentivised pools
* Supplement staking yield

Other
* Funding growth initiatives or loyalty programs
* Insurance pool
* Building a stablecoin reserve

# Conclusion
This proposal would allow the revenue captured by the ProtoRev module to accumulate within a module address. This will allow the community to assess the amount of typical value captured by the module as well as forming a reserve of capital. Accumulating a larger reserve will enable this capital to have a more meaningful impact when it is ultimately deployed.

This Revenue Reserve would be assessed no earlier than 1st June 2023. After reviewing proposals for recommended options, the community should make a decision on the direction of the ProtoRev account.

# Additional Note
While all options should be evaluated during the research phase, we believe that the community pool or DAOs with authorised spends are likely more appropriate sources of funding for any use case that would involve discrete, one-off spend. Unlike the community pool, the ProtoRev account address does not need consent from governance for each deployment of assets to every contract authorised by governance to be able to draw on funding. This enables more flexibility to create an approach that optimizes the streaming of funds to maximize impact. This post included a few potential options, but we welcome community members to put forth any ideas with supporting analysis and engage in discussion over the next 4 months.

Commonwealth Thread: https://commonwealth.im/osmosis/discussion/9615-protorev-revenue-allocation-proposal