Why CoW AMMs Act as Enhanced Index Fund

When CoW DAO released CoW AMM, its goal was simple: help liquidity providers keep hold of their liquidity. Why was this a problem? Outside of stable-to-stable pools, liquidity providers typically lose 5-7% of their liquidity each year. It’s the dirty secret of automated market making: hundreds of millions of dollars of LP funds are stolen by arbitrageurs every year.

These losses are known as loss-versus-rebalancing (LVR). LVR is a bigger source of MEV than frontrunning and sandwich attacks combined. CoW AMM is the first product CoW DAO built that directly keeps LVR out of liquidity pools.

Since its inception, LPs have been protected from LVR, and also benefited from CoW AMM’s batch auction and solver system. This has meant LPs have enjoyed additional surplus, as solvers work to find the most effective way of rebalancing liquidity pools.

Providing liquidity on CoW AMM has changed the liquidity provider game to such an extent, CoW AMMs behave more like Enhanced Index Funds than the leaky pools of old.

In this article we explain why that’s happened, and what doors CoW AMMs open for more sophisticated pools in future. CoW AMMs are evolving, fast, meaning the possibilities for liquidity providers are changing too.

What is an Index Fund?

An index fund is a type of mutual fund (a professionally managed investment portfolio that pools money from many investors to purchase securities) or exchange-traded fund (ETF) that tracks the performance of a specific index by buying stocks of every company in that index.

Index funds are a popular choice for investors because they are a low-cost way to diversify their investments, all the while being passive: no fund manager is actively creating an investment strategy, and charging hefty fees for the privilege. They are so popular, index funds, as well as other kinds of passive investors hold 33.5% of the US stock market.

Index funds typically outperform hedge funds running fancy investment strategies. So much so, legendary investor Warren Buffett made a $1 million bet in which he wagered that an S&P 500 index fund would outperform a hedge fund over ten years.

These funds can be designed to track anything from the price of a commodity to a large and diverse collection of securities. ETFs, or exchanged traded funds meanwhile, can be designed to track specific investment strategies. Those strategies could be for different purposes: income generation to speculation or to partly offset risk in an investor’s portfolio.

But these aren’t the only types of Index Funds. There are also Enhanced Index Funds, which we explore in the next section.

What is an Enhanced Index Fund?

If an Index Fund is a passive fund, an enhanced index fund (EIF) is a fund that uses active management to improve returns. They typically use a combination of active and passive investing strategies to generate returns that are higher than the benchmark while keeping risk within a controlled level.

The ‘enhanced’ part of the Index Fund is where experts assess which assets inside an index are performing strongly, and which are performing poorly. Once identified, an EIF can be rebalanced, to increase the weighting of one asset, and reduce the asset for another to help the overall fund perform better.

This management falls under a broader category called portfolio theory. It is a branch of finance that studies how people should design their portfolios. At a super high level, it says that:

• People should care both about expected returns and risk.

• Holding multiple assets instead of a single asset (i.e., diversification) is valuable because it reduces risk.

• The problem with diversification is deciding how much to invest in each asset, and several theories exist on how to do so. But broadly speaking, an asset should constitute a higher share (or weight) of the portfolio if its expected future return is high, its volatility is low, and its correlation with the rest of the portfolio is also low.

Now that we understand the principles behind Index Funds and Enhanced Index Funds, let’s turn to how CoW AMMs behave like EIFs, and what that means for crypto more broadly.

What is a CoW AMM?

CoW AMM is the first product on any blockchain to tackle the Loss-Versus-Rebalancing problem head on.

LVR is a form of maximal extractable value (MEV) responsible for more price exploitation than all other forms of MEV combined. Many liquidity providers haven’t even heard of LVR, but it costs them 5–7% of their liquidity, resulting in hundreds of millions lost each year. In fact, when accounting for LVR, many of the largest liquidity pools are not profitable for LPs at all.

The CoW AMM is a special kind of automated market maker designed to help liquidity providers capture MEV from arbitrageurs.

Here’s how it works:

1. Liquidity providers deposit tokens into protected CoW AMM liquidity pools

2. This liquidity becomes available to CoW Swap traders, who can access it similarly to other sources of liquidity

3. Solvers bid to rebalance CoW AMM pools whenever there is an arbitrage opportunity

4. The solver that offers the most surplus to the pool wins the right to rebalance the pool

This design eliminates LVR by capturing arbitrage value for LPs and shielding it from MEV bots.

Said another way: while most AMMs allow arbitrageurs to make money at the expense of their LPs, CoW AMM protects this money for the LPs instead.

Why does a CoW AMM act as an Enhanced Index Fund?

As highlighted in earlier sections, Index Funds passively follow an asset or strategy. Because LVR is removed, whenever prices change the AMM will be rebalanced so to make sure that its total TVL is split between the different assets in a pre-specified way: 50/50 for standard constant product, and 80/20 for 80/20 pools.

The AMM therefore behaves like a simple index with two components. But CoW AMM pools go one step further: liquidity providers earn trading fees whenever liquidity in the AMM is used to fulfil a user order.

Does this mean all liquidity pools can be considered to behave similarly to an Enhanced Index Fund. Not exactly. The simple answer is LVR. CoW AMM was the first on-chain product that solves this. Other pools leak liquidity meaning they aren’t as viable an option as a CoW AMM for investors looking for more consistent returns.

With the launch of 80/20 pools, LPs have more options. These pools now offer features including:

• Asymmetric upside

• Reduced impermanent loss

• Hedging

In essence, these pools can maximize exposure to the native token while providing an avenue to boost returns via trading fees and token rewards.

But this is just the beginning

For now, this is limited to simple, fixed-weight rebalancing strategies, but in the future, more complex passive investment strategies will be possible. For example, a multi-token CoW AMM could have a “manager” who can change its weights and add and remove assets.

At present CoW AMM pools feature just two assets. But in future, CoW AMMs will be capable of hosting multi-asset pools. Over on Balancer, there are already 8-asset pools featuring multiple tokens within a single pool.

Liquidity providers are able to set up their own pools with custom token splits and weights. This level of customization helps providers have full control over their portfolios and plan to reduce their exposure to risky assets. It also enables low-fee swaps for traders using those same pools.

CoW DAO has plans to bring multi-asset pools with customisable weights to liquidity providers in future with its class-leading LVR protection. They’re called Decentralized Trading Funds or DTFs.

The Decentralized Traded Fund offers the chance for holders to earn a passive income. It combines the ability to gain exposure to assets, but also the ability to enter and exit the fund whenever it is convenient. On top of that, a DTF does not require holders to pay a fee to CoW DAO. More on that in the coming weeks.

The end game is a market mechanism that allows retail investors who want to run simple passive investment strategies to do so by contributing liquidity to AMMs, while earning additional returns.

If traditional finance is an indication, these AMMs could attract up to a third of the total market cap of various assets as liquidity, providing super-efficient trading at close to zero slippage.

Decentralized finance will finally provide better market mechanisms than traditional finance, opening the door to rebuilding the financial system on blockchain rails.