The PlayStation 5 eBay Market

The emergence of DeFi has introduced a wave of marketing language that is both creatively enthusiastic and, in many cases, ultimately devoid of substance. Terms that once held well-defined meanings, such as “capital efficiency”, “fees”, “loss versus rebalancing”, and “toxic flow”, have become embroiled in the hubris of DeFi’s marketing hive mind. It is conspicuous that much of the industry’s success can be attributed to social media, where appeals to emotion and the distinctly human desire to be a member of the tribe are the primary focus. Consequently, it should come as no surprise that very simple financial concepts have taken on unnecessary ambiguity as communities in DeFi repurpose them to attract more tribe members. In this context, the precise communication of a financial concept becomes secondary to its emotional and social resonance.

Moreover, a notable aspect of this dynamic is the attitude of the DeFi users themselves. There is a discernible demand for access to sophisticated financial protocols, coupled with a resistance to engaging with the educational efforts necessary to use these tools effectively. Users often seek the benefits of DeFi participation without investing the time to understand the underlying principles. This paradoxical expectation has led to a form of communication within the DeFi space that prioritizes social engagement and often deliberately overlooks the more substantive, albeit less glamorous, foundational aspects of DeFi protocols.

The irony is that, while mundane, the underlying concepts are not at all challenging. However, I suspect that the added level of abstraction afforded by their context inside of the blockchain narrative can make it difficult to see the forest for the trees. To strip away the layers of ambiguity and social influence standing in the way of what should be accessible knowledge, I am going to focus on a more comfortable and practical analogy: the eBay market for the PlayStation 5 Blu-Ray Edition. This comparison with respect to the “Buy It Now” feature for merchants on eBay is quite nearly perfect; however, for the bidding prices we are going to take some poetic license by imagining a restructuring of eBay that, quite frankly, would bring some interesting new functionality to their platform. This approach aims to offer a more objective understanding of the core principles of exchange protocols, untangled from the tribalism and postmodern subjection of the communities that wield them.

The PlayStation 5 (Blu-Ray Edition) eBay Market

I am deliberately constraining the scope of eBay’s market for PlayStation 5’s (on the maker side) to something relatively straight-forward. I have no intention of aggregating this in any meaningful sense; the objective of this discussion is to arrive at a useful understanding of blockchain exchange primitives, not to embark on a thorough investigation of secondary consumer electronics markets. To collect a homogenous sample, I am focusing on the Blu-Ray Edition for the sole reason that there are more of them.

Figure 1: eBay PlayStation 5 market search.

I checked each listing to confirm that it was what it claimed; in some cases the disc drive needed to be selected from a dropdown menu to get the correct quote price. At least half of these listings are bundled together with a game. Anecdotally, whether a game is included with the bundle has zero correlation with the unit price. For each listing I recoded the quote and shipping value, and the number of units still for sale. There were two instances where a purchase of more than one console resulted in a discounted price on a per-unit basis. For these I assumed buying all the listed stock, thereby achieving the maximum discount. In another two instances, the number of units for sale was simply listed as “more than ten”. In these cases, I recorded the number of units as 11 and moved on.

Figure 2: Typical eBay PlayStation 5 seller’s page.

The PlayStation 5 (Blu-Ray Edition) eBay Depth Chart

Imagine that we live in a world where market takers (i.e. people buying PlayStation 5s) are rational, and consistently make good decisions. Completely divorced from reality though this may be, it is a necessary concession when analyzing the available market. We therefore assume that when interacting with the market, all else being equal, the taker will elect to purchase the most inexpensive PlayStation 5 first. After the transaction is made, that stock is removed from the marketplace. If there are more units available at the same price, the next consumer is unaffected; however, if the stock at the lowest price is depleted, then the next consumer is forced to interact with the next available unit at whatever its listing price is.

This situation is absolutely within the grasp of everyone using DeFi:

There are a limited number of PlayStation 5s on the market.
They are spread out over a range of asking prices by vendors.
If you want to buy a PlayStation 5, it is sensible to buy one at the lowest available
asking price.
After all the PlayStation 5s available at a single price point are consumed,
the next available asking price will be greater than the one that was just exhausted.

It is reasonable to ask how much retail business the PlayStation 5 market on eBay can sustain at a certain price level, or all price levels. To investigate, imagine buying each PlayStation 5 listed on eBay one by one, beginning from the lowest listing price and working your way up. As you perform each transaction, record the listing price for the PlayStation 5 you just bought, and the running total of all the money you have spent purchasing them. The plot of this data is called a market depth chart.

The eBay PlayStation 5 market depth is an important characteristic, because it reports how much the asking price of a PlayStation 5 is likely to increase given a surge in consumer demand. For example, imagine that you were tasked with buying a bunch of PlayStation 5s for Santa Claus to deliver to well-behaved human offspring at Christmas. Santa’s instructions are that you can only purchase a PlayStation 5 if it costs $1,200.00 AUD or less. From the chart below, you can tell immediately that you are going to spend $131,126.32 AUD buying PlayStations (including postage!); although, since the depth is reported in dollars it is not immediately clear precisely how many PlayStations you are buying. All you know is that after you are done, the first available price to the next consumer will be >$1,200.00 AUD. Therefore, market depth charts are more concerned with cash flow than the commodity it is paired with.

Again, I posit that this is not a challenging concept for DeFi users:

From examination of the depth chart, we can conclude that:
a purchase of $131,126.32 AUD worth of PlayStation 5s from eBay will
move the asking price from $720.95 AUD to > $1,200 AUD,
(i.e. > +66.45%).

Figure 3: eBay PlayStation 5 asking depth.

The PlayStation 5 (Blu-Ray Edition) eBay Bonding Curve

To determine how many PlayStation 5s will be adorning the televisions of deserving children (within budget), we can simply plot the loss of PlayStation 5 inventory by eBay merchants as a function of the increase in their cash balances. The starting PlayStation 5 inventory is 181 units, and the remaining inventory as the collective cash balance of the merchants approaches $131,126.32 AUD is 54 units; therefore, only 181–54 = 127 special children are receiving a PlayStation 5 for Christmas.

Figure 4: eBay PlayStation 5 asking bonding curve.

This kind of plot has become known as a “bonding curve” throughout DeFi. Notice that in this form the price data is sacrificed, so by itself is not especially useful. However, paired with the depth chart, the two together provide a phenomenally detailed snapshot of the current market. That is, assuming you are considering buying a suspicious quantity of PlayStations from eBay in a short timeframe. This is an important point: these kinds of analyses assume that you are buying all units at once before the vendors have time to react. If you are buying PlayStation 5s one-at-a-time, slowly over the course of hours or days, it is reasonable to expect that the vendors might move their prices up in anticipation of the oncoming demand. This kind of market reaction does not apply to AMMs, and so is outside the scope of the discussion.

While Santa’s instructions were to only purchase PlayStation 5s under the predicate that each one cost $1,200.00 AUD or less, we have still only spent a total of $132,126.32 AUD and acquired 127 consoles, which is an average of $1,032.49 AUD per unit. If we interpret Santa’s instructions to mean that we should spend no more than an average of $1,200.00 AUD per PlayStation 5, then we can afford to take the entire PlayStation 5 market at an average price per unit of $1,096.02 and still be under budget.

While this is a more common depiction in DeFi, I suspect that it is still a source of confusion for many:

The bonding curve is a plot of the eBay merchant’s PlayStation 5 inventory versus their cash balances.
As PlayStation 5s are sold, they are removed from the inventory (i.e. -ΔPlayStation 5)
and $AUD is added to the cash balance (i.e. +ΔAustralian Dollars).
The average price per PlayStation 5 when buying multiple units is simply the total units received from the vendor divided by the total cash paid.

The eBay We All Deserve but Can’t Have

As it stands, eBay allows consumers to interact with vendors in a variety of ways.

The most common is the situation already explored in the previous section, where vendors list their PlayStation 5s with specific asking prices, and consumers can browse the available asking prices before deciding to purchase.
Long ago, the most common interaction was via the auction mechanic, where the vendor provides the item and consumers bid against each other.
The third and final supported interaction is where the vendor may elect to accept offers — meaning that the item is listed with a certain asking price, but the consumer can negotiate a lower price.

Imagine a fourth mode of interaction, where consumers could list their cash with the “price” being an item they wish to purchase. Distinct from the third type of interaction, instead of offering cash to only the vendors who have elected to allow price negotiations, you could offer cash to all vendors, simultaneously. Such a system would align well with free market ideals; allowing consumers to list cash offers could lead to a more competitive and efficient market for PlayStation 5s.

Figure 5: Imagined eBay PlayStation 5 bidding page.

While this fourth type of interaction is currently absent (eBay, if you are reading this — call me), the auction component of the system for which they were once known is still alive and well, albeit much less popular than it was in its glory days. The auction mechanics are recorded and apparently freely auditable directly via the page wherein an auction is taking place (although, a login is required). I expanded the scope of the PlayStation 5 market probe to include those listings currently being actively bid on, and scraped their bidding history to get an idea of what the other side of the market might look like, were those without a PlayStation allowed to offer their cash directly to those with one, on their own terms.

Figure 6: Typical eBay PlayStation 5 bidding history.

I didn’t spend a huge amount of time on this — nor could I if I wanted to. At the time of writing there were only five relevant auctions, and only two of them were being bid on, and only by 12 different users. The other three auctions had their commencing bids (i.e. the one requested by the merchant) set well out of the money with respect to the market already available, which explains the lack of activity. Regardless, I collected 30 data points that represent individual prices that users had expressed an interest in transacting at. Never mind that we are demonstrably double counting the cash market; just pretend that each bid was from a unique user and that their offers were posted as listings on eBay proper, instead of being asked to compete for the same items in a live-auction format.

Thus, we can construct a depth chart as we have previously, but this time on the bids side. Imagine selling PlayStation 5s into this market, where consumers are offering cash via an eBay listing. Start by selling your PlayStation 5 inventory, one by one, beginning from the highest available bidding price and working your way down. As with the previous exercise, as you perform each transaction, record the bidding price for the PlayStation 5 you just sold and the running total of all the cash you have collected from consumers in the process. Since PlayStation 5 sellers taking this market are motivated to get the highest price, the bidding depth chart is mirrored relative to the asking depth chart; the market depth to sell PlayStation 5s improves as we approach lower prices.

Nothing surprising or difficult here, either:

There are a limited amount of cash offers on the market.
They are spread out over a range of bidding prices by consumers.
If you want to sell a PlayStation 5, it is sensible to sell it at the highest available bidding price.
After all the cash offers at a single price point have been taken,
the next available bidding price will be less than the one that was just exhausted.

This depth chart may be of interest if you have a large stockpile of PlayStation 5s, as it reports how much cash you could obtain quickly if you had to liquidate your inventory. For example, imagine you are tasked with liquidating Santa’s reserves of PlayStations after the United States Department of Justice charges him with wire fraud, money laundering, and conspiracy thereof. Your instructions are to not relinquish any PlayStations for less than $600.00 AUD apiece. Again, the depth chart self-reports that you will be able to liquidate $7,054.50 AUD worth of consoles, but it doesn’t tell you how many consoles that equates to.

To determine how many PlayStation 5s will be unloaded onto the market, we can simply plot the loss of Australian Dollars by consumers as a function of function of their increase in PlayStation 5s. Consumers begin with $16,673.50 in bidding liquidity, and their PlayStation 5 inventory approaches 10 as we take $7,054.50 AUD of their market. Therefore, we can afford to liquidate 10 PlayStation 5s without selling one beneath the $600 per unit mandate. As before, if we interpret our instructions as meaning an average of $600 AUD per unit, we can afford to take $12,725.95 of the cash market for an average of $606.00 AUD per console.

Figure 7: eBay PlayStation 5 bidding depth.

Figure 8: eBay PlayStation 5 bidding bonding curve.

Taking Both Sides of eBay’s PlayStation 5 Market

It might be reasonable to expect that between holiday seasons the demand for PlayStation 5s could begin to wane — but the overheads of operating a retail electronics outlet remain consistent. When business is slow and with the tax season approaching, there could be an opportunity to squeeze the retailers for their precious PlayStation 5 inventory. Consider this: in a market that’s not as buoyant, the urgency to maintain cash flow might compel some retailers to turn to the cash offers in our re-imagined version of eBay, and this is where a discerning trader finds their niche.

Imagine then, strategically acquiring PlayStation 5s from these retailers when they’re most eager to sell. The real opportunity unfolds as the year progresses towards December, a time traditionally marked by a surge in demand, often driven by parents seeking to fulfill holiday wishes.

Now suppose that you could refuse delivery on the PlayStations you acquire and can instead opt to warehouse them free-of-charge in eBay’s depots. Then, after each transaction your eBay page immediately and automatically lists the console you just bought with more optimistic holiday season prices. Later, when you find a buyer at your asking price, the cash you receive immediately goes back on your eBay page, again offering cash for PlayStation 5s at a lower bidding price, in cycles, ad infinitum.

This is not as absurd as you might think. This practice of taking both sides of a market simultaneously, and the profit motive for doing so, is the business of professional market makers, typically large financial institutions or firms. However, in our context, both with respect to the PlayStation 5 on eBay and exchange primitives for cryptocurrency tokens on a blockchain, the scaled-down version of professional market making is nearly indistinguishable from the business of a pawn broker. I concede that the scale, regulatory environment, and nature of transactions (individual consumer goods vs. standardized financial instruments) are quite different, but the profit mechanism is literally identical:

Offer cash at a bidding price for something while
simultaneously offer the thing you are bidding on at a higher asking price.

I know it sounds trite — but there really is only one way to make money trading: Buy Low, Sell High, Repeat. It’s all there is, it’s all we’ve got, it’s not complicated, and it never was. Whether it is buying and selling PlayStation 5s on eBay via the warehousing method described above or providing token liquidity to a decentralized exchange, the financial fundamentals are indistinguishable. And I can prove it.

Using eBay as an Automatic Market Maker for PlayStation 5s

The canonical automatic market maker hasn’t changed at all since its inception in 2017. Its most familiar form is the one consisting of exactly two assets with equal portfolio weights, also known as the “constant product” or the xy = k pricing algorithm. This is the context where most DeFi users will have first encountered the concept of a “fee”; the common understanding is that use of their liquidity incurs additional charges from market participants, which accumulates to the value of their portfolio. Unfortunately, this description completely obfuscates the true nature of their activities. There is no such thing as a “fee” on a decentralized exchange, any more than there is on eBay. In fact, there is nothing stopping us from re-creating the xy = k AMM on our improved version of eBay (i.e. delivery refusal, warehousing, and the ability to list cash in exchange for goods).

For this exercise, we will begin with a PlayStation 5 inventory of 100 units, and $158,000 AUD in cash. Assume that the mid-market price for a new console is $1,580.00 AUD, and that we acquired all consoles in the inventory at this price. Using the xy = k pricing algorithm with a δ term of 0.2 (aka the “fee” parameter; 0.2 is unusually high but it doesn’t matter here), we would list our first PlayStation 5 for $2,000 AUD, and we would list our first cash offer at $1,251.49 AUD. Meaning, we are offering to buy a PlayStation 5 from anyone who would wish to sell one to us for $1,251.49 AUD and, simultaneously, we are offering to sell a PlayStation 5 to anyone who wants one for $2,000 AUD, thereby achieving a bid-ask spread of $2,000.00 AUD — $1,251.49 AUD = $748.51 AUD. Those are just our highest bidding and lowest asking prices; we have 99 more consoles in our inventory and another $156,748.50 AUD in cash reserves with which to create a market:

Table 1: The PlayStation 5 xy = k AMM bids and asks table.

Due to a quirk of the xy = k pricing algorithm, the last PlayStation 5 in the inventory is priced at infinity dollars, and the second to last unit carries an asking price of more than a third of a billion dollars. However, our cash bids are limitless; the 5189th consecutive bid is the last time we offer the market more than $1.00 AUD for a PlayStation 5.

I have shown these rows for completeness’ sake only. It is obvious that some of these prices are absurd. If we limit our market making to the first five rows, then we would only need $6,042.47 AUD and five PlayStation 5s, which would emulate an “amplified liquidity” position (also known as “concentrated liquidity”), meaning that despite having significantly less inventory and cash reserves, it continues to behave as though it contains 100 units and $158,000 AUD with respect to the xy = k model. The amplified version simply restricts the available market depth to whatever cash and inventory is provided without affecting the bidding and asking prices. Therefore, with fewer resources you could service the same market — provided it doesn’t overwhelm your bidding and asking prices. The DeFi community has somewhat misleadingly co-opted the term “capital efficiency” to describe this behavior, perhaps to invoke ideas of financial growth and profitability. “However, it can be inferred from its usage that the appropriation of the term in DeFi specifically compares one pricing model to another:

One pricing model is more capital efficient than another if
by default it offers higher bidding prices and lower asking prices
normalized to the same inventory and cash balances.

Figure 9: xy = k AMM PlayStation 5 bidding and asking depth.

Figure 10: Concentrated AMM PlayStation 5 bidding and asking depth.

Since our eBay store is adopting the prototypical Concentrated AMM pricing model, it is important to acknowledge that as the market takes PlayStation 5s from our inventory (i.e. as our asking prices are taken), our cash reserves are increasing, but also our bidding prices are updated. In a continuous liquidity situation the spread between the marginal bid and ask is a constant proportion, and is simple to calculate:

However, since customers are expecting to transact in whole PlayStation 5s, instead of fractions of a PlayStation 5, we will need to correct for price slippage, which in turn requires the relative amplification of our inventory to be appropriately accounted for (i.e. the reduced slippage of the concentrated position):

where:

x is the remaining PlayStation 5 inventory,
x₀ is the initial PlayStation 5 inventory (i.e. 5, in this example),
δ is the [unhelpfully named] “fee” parameter, in our case set to 0.2, and
A is the amplification coefficient, in this case 100/5 = 20.

Again, this is not difficult. I am aware that an equation or two may inspire fear and anxiety for many — but hear me out; all we are doing is establishing the rules for our eBay page(s) that:

adjust the bidding prices up as buyers take our PlayStation 5 market;
adjust the asking prices down as sellers take our cash market.

This gets easier with illustration. Suppose that after setting up our five asking prices and five bidding prices (Table 1) we make our first transaction: a PlayStation 5 seller takes our highest bidding price; our PlayStation inventory increases by one and we lose $1,251.49 AUD from the cash reserves. The other cash listings are unaffected; the next highest bid remains at $1,229.40. However, as the newly acquired PlayStation 5 is added to our store inventory, not only is it appended to the existing asks, but every single asking price is also adjusted according to the general spread formula.

Table 2: The PlayStation 5 bids and asks table after taking the first bid.

Figure 11: Updates to the asking depth after taking the first bid.

Assume that the PlayStation 5 seller’s appetite continues to increase, and they begin to accept the lower bidding prices, until there is only 1 PlayStation 5 left in the inventory.

Table 3: The PlayStation 5 bids and asks table after taking the first four bids.

Figure 12: Updates to the asking depth after taking the first four bids.

At this stage, all we have done is acquire four additional PlayStation 5s at an average of cost of $1,218.95 AUD per unit. Note that the model here is 1:1 with an AMM on the blockchain, save for some minor implementation-specific details. We listed five PlayStation consoles at five different prices, and four of them were bought. As a specialist PlayStation 5 pawn broker on eBay, and equally, as a token liquidity provider to a decentralized exchange, there are only two things you care about:

The acquisition costs and
the sale price,
not necessarily in that order.

This is the critical realization, and what I believe to be the most thoroughly misunderstood concept in all DeFi: the question as to what the fee earnings are up to this point. The short answer is that there is no fee; liquidity providers to AMMs do not charge fees, and so the “fee earnings” calculation is devoid of meaning. A better question — one which is more founded in financial reality, is whether the trading strategy is profitable. The answer is that before we can claim to have turned a profit, we need to sell the PlayStation 5 inventory back to the market at a higher price than it was acquired for.

That is really all there is to this. Bid low on PlayStation 5s when sellers are getting anxious and ask high when the market demand is increasing. There is no other profit mechanism.

Suppose that sometime after the market takes most of our cash reserves, the nine PlayStation 5s we have listed start to receive some interest. Then, finally, a PlayStation 5 buyer takes our lowest asking price; our PlayStation inventory decreases by one and our cash reserves recover by $1,862.82 AUD. The other PlayStation 5 listings are unaffected; the next lowest ask remains at $1,904.02 AUD. However, as the cash comes in, it is immediately added to cash listings and the bidding prices are updated according to the general spread formula. This is the exact reverse of the situation where our cash market was being taken.

Table 4: The PlayStation 5 bids and asks table after taking the first ask.

Figure 13: Updates to the bidding depth after taking the first ask.

Assume that interest in the PlayStation 5 market continues to develop, and buyers begin to accept the higher asking prices until there are only four PlayStations left in the inventory.

Table 5: The PlayStation 5 bids and asks table after taking the first five asks.

Figure 14: Updates to the bidding depth after taking the first five asks.

There is exactly one correct way to evaluate the performance of this trading strategy, and there is nothing subjective about it:

We started with $13,942.47 AUD in cash,
exchanged $7,900.00 AUD for five PlayStation 5s at the mid-market rate ($1,580.00 AUD), then
used the remaining $6,042.47 AUD to set up a cash market on eBay for an additional five consoles, while
simultaneously making the market for PlayStation 5s starting at an asking price of $2,000.00 AUD.
We acquired four additional consoles at an average price of $1,218.96 AUD per console, then
sold five consoles at an average price of $1,947.93 AUD.
The final balance sheet is $10,906.28 AUD in cash, and
four PlayStation 5s with a combined nominal value of $8,143.20 if we trust the last unit sale price,
culminating in a portfolio value of $19,049.48 and an unrealized profit of $5,107.01 (36.6%).

Note that the profit here is still unrealized. The starting cash balance was $13,942.47 and we still only have $10,906.28 in reserve. The four unsold consoles are still an outstanding liability until their value is consolidated back into Australian Dollars.

This is literally everything you ever needed to know about providing liquidity to a market — be it for PlayStation 5s, or via the ETH/USDC liquidity pool on your favourite AMM. My ambition with this illustration is not only to demonstrate that the common understanding of the “fee” parameter on an AMM is dangerously removed from reality, but also to bring attention to the fact of the matter — liquidity provisioning is a trading strategy. There is no ambiguity, no benefit of the doubt, nothing is left to interpretation.

Some things simply are, regardless of how we feel about it.

The Hubris of the Defeated

As with the misappropriation of the term “capital efficiency”, use of the term “toxic flow” (image related) in DeFi has become all but meaningless. That is not to say that toxic flow is not a real phenomenon — it absolutely is, and its effects range from a market nuisance to financial devastation. I’d like to extend my appreciation to the original author of Toxic Order Flow on theforexgeek.com for providing some much needed clarity, and from whom I have paraphrased the following bullets regarding what constitutes legitimate toxic order flow.

Spoofing: This involves a trader placing an order without any intention of letting it execute. Their goal is to falsely signal strong demand or supply, manipulating the asset’s price. After the price shifts favorably, they retract their order, capitalizing on this artificial movement.
Layering: Like spoofing, layering consists of setting up several orders at varied price points. This creates an illusion of significant trading activity, swaying the asset’s price. The trader then withdraws these orders, benefiting from the resultant price shift.
Marking the Close: Here, a trader executes a substantial order at or near the market’s closing time. This strategy aims to affect the closing price, which can also misrepresent the asset’s demand or supply, influencing its price.
Order Stuffing: This tactic involves flooding the market with numerous orders in a brief timeframe. The overload can cause processing delays and disrupt the normal pricing of the asset.
Front Running: In this scenario, a trader exploits advance knowledge of an impending order. By acting on this information, they position themselves to profit from the price changes that will follow once the large order is executed.
Insider Trading: This is trading based on confidential, non-public information. For instance, a company insider might buy stock before a positive announcement, aiming to sell it post-announcement for a profit.

In contrast, the concept of toxic flow in DeFi is, for lack of a better description, an imagined external tormentor that is summoned by those who end up on the losing side of bad trade (by providing liquidity to it). It is a convenient scape goat for bad businesses who get upset when they exit from their PlayStation 5 inventory only to see those same units for sale the following day at mark-up. Or, conversely, the pawn brokers who bought those PlayStations only to find that it is impossible to flip them for a profit later.

I speculate that there is, in fact, a good reason for this term to have entered the DeFi vocabulary in the context of AMMs and liquidity provisioning. Consider that despite my best efforts to make the material presented here as accessible as possible, for many DeFi users the subject matter is simply not interesting (no judgement!). My suspicion is that the people that belong to this category share a significant part of their Venn Diagram with those who don’t understand why their LP positions are losing money. Armed with only the dangerous half-knowledge afforded them by the paid shills on Twitter and YouTube, failure to perform financially could seem deeply mysterious. Together with the common misconception that losses on an LP position can be partially or wholly attributed to the actions of arbitrageurs, a crowd-sourced vision of the bogeyman on whom we can pin our accusations of unfair practices does emerge.

But this is a mistake.

The analysis in the previous section is perfectly valid on its own and does not require any additional context. In short, your trading profits and losses are what they are, irrespective of the motivations that drive eBay’s buyers and sellers to trade with you. The true toxic flow is not from those who interacted with a market you created — it is from those who would prefer the convenience of selling you on the idea of “capital efficiency” and “fees” and then never explain to you what either of those things really mean.

Conclusion

In this examination, the tangible case of eBay’s PlayStation 5 market has been utilized to elucidate the financial principles underlying liquidity provision in Automated Market Makers (AMMs). This analysis, while comprehensive and perhaps somewhat technical, demonstrates that these concepts are accessible to individuals engaging with DeFi primitives on the blockchain.

The DeFi sector is often characterized by the use of marketing buzzwords and emotive narratives. While these elements play a role in fostering enthusiasm and driving adoption, they can also veil the true nature of the financial decisions inherent in these protocols. An examination of eBay’s market dynamics offers a clear parallel to the activities of DeFi liquidity providers, particularly in the context of market making and pawn brokering. The fundamental principles of buying low and selling high are universally applicable, transcending specific claims about the uniqueness of any given protocol, regardless of its tokenomics.

The notion of ‘toxic flow’, frequently misunderstood or misapplied in the context of DeFi, is critically assessed. It is often cited as a rationale for losses in unfavorable trades or as a placeholder for a user’s misunderstanding of the pricing algorithm to which they are subscribed. In contrast, traditional market manipulations such as spoofing, layering, and insider trading represent genuinely toxic activities, though they are not typically the focus when ‘toxic flow’ is discussed within DeFi circles.

As the DeFi industry progresses, it becomes essential to engage with target audiences under the premise that they seek to remain informed and critical. Rapid and efficient user onboarding processes should not eclipse the responsibility of protocol developers to offer adequate resources for self-education to those of reasonable intelligence. The aim of this article is to demonstrate that the financial theories underpinning DeFi exchange primitives are straightforward enough that the lack of basic understanding among many users is somewhat inexplicable and we, the industry leaders, should have a plan to address that.

The emergence of DeFi has introduced a wave of marketing language that is both creatively enthusiastic and, in many cases, ultimately devoid of substance. Terms that once held well-defined meanings, such as “capital efficiency”, “fees”, “loss versus rebalancing”, and “toxic flow”, have become embroiled in the hubris of DeFi’s marketing hive mind. It is conspicuous that much of the industry’s success can be attributed to social media, where appeals to emotion and the distinctly human desire to be a member of the tribe are the primary focus. Consequently, it should come as no surprise that very simple financial concepts have taken on unnecessary ambiguity as communities in DeFi repurpose them to attract more tribe members. In this context, the precise communication of a financial concept becomes secondary to its emotional and social resonance.

Moreover, a notable aspect of this dynamic is the attitude of the DeFi users themselves. There is a discernible demand for access to sophisticated financial protocols, coupled with a resistance to engaging with the educational efforts necessary to use these tools effectively. Users often seek the benefits of DeFi participation without investing the time to understand the underlying principles. This paradoxical expectation has led to a form of communication within the DeFi space that prioritizes social engagement and often deliberately overlooks the more substantive, albeit less glamorous, foundational aspects of DeFi protocols.

The irony is that, while mundane, the underlying concepts are not at all challenging. However, I suspect that the added level of abstraction afforded by their context inside of the blockchain narrative can make it difficult to see the forest for the trees. To strip away the layers of ambiguity and social influence standing in the way of what should be accessible knowledge, I am going to focus on a more comfortable and practical analogy: the eBay market for the PlayStation 5 Blu-Ray Edition. This comparison with respect to the “Buy It Now” feature for merchants on eBay is quite nearly perfect; however, for the bidding prices we are going to take some poetic license by imagining a restructuring of eBay that, quite frankly, would bring some interesting new functionality to their platform. This approach aims to offer a more objective understanding of the core principles of exchange protocols, untangled from the tribalism and postmodern subjection of the communities that wield them.

The PlayStation 5 (Blu-Ray Edition) eBay Market

I am deliberately constraining the scope of eBay’s market for PlayStation 5’s (on the maker side) to something relatively straight-forward. I have no intention of aggregating this in any meaningful sense; the objective of this discussion is to arrive at a useful understanding of blockchain exchange primitives, not to embark on a thorough investigation of secondary consumer electronics markets. To collect a homogenous sample, I am focusing on the Blu-Ray Edition for the sole reason that there are more of them.

Figure 1: eBay PlayStation 5 market search.

I checked each listing to confirm that it was what it claimed; in some cases the disc drive needed to be selected from a dropdown menu to get the correct quote price. At least half of these listings are bundled together with a game. Anecdotally, whether a game is included with the bundle has zero correlation with the unit price. For each listing I recoded the quote and shipping value, and the number of units still for sale. There were two instances where a purchase of more than one console resulted in a discounted price on a per-unit basis. For these I assumed buying all the listed stock, thereby achieving the maximum discount. In another two instances, the number of units for sale was simply listed as “more than ten”. In these cases, I recorded the number of units as 11 and moved on.

Figure 2: Typical eBay PlayStation 5 seller’s page.

The PlayStation 5 (Blu-Ray Edition) eBay Depth Chart

Imagine that we live in a world where market takers (i.e. people buying PlayStation 5s) are rational, and consistently make good decisions. Completely divorced from reality though this may be, it is a necessary concession when analyzing the available market. We therefore assume that when interacting with the market, all else being equal, the taker will elect to purchase the most inexpensive PlayStation 5 first. After the transaction is made, that stock is removed from the marketplace. If there are more units available at the same price, the next consumer is unaffected; however, if the stock at the lowest price is depleted, then the next consumer is forced to interact with the next available unit at whatever its listing price is.

This situation is absolutely within the grasp of everyone using DeFi:

There are a limited number of PlayStation 5s on the market.
They are spread out over a range of asking prices by vendors.
If you want to buy a PlayStation 5, it is sensible to buy one at the lowest available
asking price.
After all the PlayStation 5s available at a single price point are consumed,
the next available asking price will be greater than the one that was just exhausted.

It is reasonable to ask how much retail business the PlayStation 5 market on eBay can sustain at a certain price level, or all price levels. To investigate, imagine buying each PlayStation 5 listed on eBay one by one, beginning from the lowest listing price and working your way up. As you perform each transaction, record the listing price for the PlayStation 5 you just bought, and the running total of all the money you have spent purchasing them. The plot of this data is called a market depth chart.

The eBay PlayStation 5 market depth is an important characteristic, because it reports how much the asking price of a PlayStation 5 is likely to increase given a surge in consumer demand. For example, imagine that you were tasked with buying a bunch of PlayStation 5s for Santa Claus to deliver to well-behaved human offspring at Christmas. Santa’s instructions are that you can only purchase a PlayStation 5 if it costs $1,200.00 AUD or less. From the chart below, you can tell immediately that you are going to spend $131,126.32 AUD buying PlayStations (including postage!); although, since the depth is reported in dollars it is not immediately clear precisely how many PlayStations you are buying. All you know is that after you are done, the first available price to the next consumer will be >$1,200.00 AUD. Therefore, market depth charts are more concerned with cash flow than the commodity it is paired with.

Again, I posit that this is not a challenging concept for DeFi users:

From examination of the depth chart, we can conclude that:
a purchase of $131,126.32 AUD worth of PlayStation 5s from eBay will
move the asking price from $720.95 AUD to > $1,200 AUD,
(i.e. > +66.45%).

Figure 3: eBay PlayStation 5 asking depth.

The PlayStation 5 (Blu-Ray Edition) eBay Bonding Curve

To determine how many PlayStation 5s will be adorning the televisions of deserving children (within budget), we can simply plot the loss of PlayStation 5 inventory by eBay merchants as a function of the increase in their cash balances. The starting PlayStation 5 inventory is 181 units, and the remaining inventory as the collective cash balance of the merchants approaches $131,126.32 AUD is 54 units; therefore, only 181–54 = 127 special children are receiving a PlayStation 5 for Christmas.

Figure 4: eBay PlayStation 5 asking bonding curve.

This kind of plot has become known as a “bonding curve” throughout DeFi. Notice that in this form the price data is sacrificed, so by itself is not especially useful. However, paired with the depth chart, the two together provide a phenomenally detailed snapshot of the current market. That is, assuming you are considering buying a suspicious quantity of PlayStations from eBay in a short timeframe. This is an important point: these kinds of analyses assume that you are buying all units at once before the vendors have time to react. If you are buying PlayStation 5s one-at-a-time, slowly over the course of hours or days, it is reasonable to expect that the vendors might move their prices up in anticipation of the oncoming demand. This kind of market reaction does not apply to AMMs, and so is outside the scope of the discussion.

While Santa’s instructions were to only purchase PlayStation 5s under the predicate that each one cost $1,200.00 AUD or less, we have still only spent a total of $132,126.32 AUD and acquired 127 consoles, which is an average of $1,032.49 AUD per unit. If we interpret Santa’s instructions to mean that we should spend no more than an average of $1,200.00 AUD per PlayStation 5, then we can afford to take the entire PlayStation 5 market at an average price per unit of $1,096.02 and still be under budget.

While this is a more common depiction in DeFi, I suspect that it is still a source of confusion for many:

The bonding curve is a plot of the eBay merchant’s PlayStation 5 inventory versus their cash balances.
As PlayStation 5s are sold, they are removed from the inventory (i.e. -ΔPlayStation 5)
and $AUD is added to the cash balance (i.e. +ΔAustralian Dollars).
The average price per PlayStation 5 when buying multiple units is simply the total units received from the vendor divided by the total cash paid.

The eBay We All Deserve but Can’t Have

As it stands, eBay allows consumers to interact with vendors in a variety of ways.

The most common is the situation already explored in the previous section, where vendors list their PlayStation 5s with specific asking prices, and consumers can browse the available asking prices before deciding to purchase.
Long ago, the most common interaction was via the auction mechanic, where the vendor provides the item and consumers bid against each other.
The third and final supported interaction is where the vendor may elect to accept offers — meaning that the item is listed with a certain asking price, but the consumer can negotiate a lower price.

Imagine a fourth mode of interaction, where consumers could list their cash with the “price” being an item they wish to purchase. Distinct from the third type of interaction, instead of offering cash to only the vendors who have elected to allow price negotiations, you could offer cash to all vendors, simultaneously. Such a system would align well with free market ideals; allowing consumers to list cash offers could lead to a more competitive and efficient market for PlayStation 5s.

Figure 5: Imagined eBay PlayStation 5 bidding page.

While this fourth type of interaction is currently absent (eBay, if you are reading this — call me), the auction component of the system for which they were once known is still alive and well, albeit much less popular than it was in its glory days. The auction mechanics are recorded and apparently freely auditable directly via the page wherein an auction is taking place (although, a login is required). I expanded the scope of the PlayStation 5 market probe to include those listings currently being actively bid on, and scraped their bidding history to get an idea of what the other side of the market might look like, were those without a PlayStation allowed to offer their cash directly to those with one, on their own terms.

Figure 6: Typical eBay PlayStation 5 bidding history.

I didn’t spend a huge amount of time on this — nor could I if I wanted to. At the time of writing there were only five relevant auctions, and only two of them were being bid on, and only by 12 different users. The other three auctions had their commencing bids (i.e. the one requested by the merchant) set well out of the money with respect to the market already available, which explains the lack of activity. Regardless, I collected 30 data points that represent individual prices that users had expressed an interest in transacting at. Never mind that we are demonstrably double counting the cash market; just pretend that each bid was from a unique user and that their offers were posted as listings on eBay proper, instead of being asked to compete for the same items in a live-auction format.

Thus, we can construct a depth chart as we have previously, but this time on the bids side. Imagine selling PlayStation 5s into this market, where consumers are offering cash via an eBay listing. Start by selling your PlayStation 5 inventory, one by one, beginning from the highest available bidding price and working your way down. As with the previous exercise, as you perform each transaction, record the bidding price for the PlayStation 5 you just sold and the running total of all the cash you have collected from consumers in the process. Since PlayStation 5 sellers taking this market are motivated to get the highest price, the bidding depth chart is mirrored relative to the asking depth chart; the market depth to sell PlayStation 5s improves as we approach lower prices.

Nothing surprising or difficult here, either:

There are a limited amount of cash offers on the market.
They are spread out over a range of bidding prices by consumers.
If you want to sell a PlayStation 5, it is sensible to sell it at the highest available bidding price.
After all the cash offers at a single price point have been taken,
the next available bidding price will be less than the one that was just exhausted.

This depth chart may be of interest if you have a large stockpile of PlayStation 5s, as it reports how much cash you could obtain quickly if you had to liquidate your inventory. For example, imagine you are tasked with liquidating Santa’s reserves of PlayStations after the United States Department of Justice charges him with wire fraud, money laundering, and conspiracy thereof. Your instructions are to not relinquish any PlayStations for less than $600.00 AUD apiece. Again, the depth chart self-reports that you will be able to liquidate $7,054.50 AUD worth of consoles, but it doesn’t tell you how many consoles that equates to.

To determine how many PlayStation 5s will be unloaded onto the market, we can simply plot the loss of Australian Dollars by consumers as a function of function of their increase in PlayStation 5s. Consumers begin with $16,673.50 in bidding liquidity, and their PlayStation 5 inventory approaches 10 as we take $7,054.50 AUD of their market. Therefore, we can afford to liquidate 10 PlayStation 5s without selling one beneath the $600 per unit mandate. As before, if we interpret our instructions as meaning an average of $600 AUD per unit, we can afford to take $12,725.95 of the cash market for an average of $606.00 AUD per console.

Figure 7: eBay PlayStation 5 bidding depth.

Figure 8: eBay PlayStation 5 bidding bonding curve.

Taking Both Sides of eBay’s PlayStation 5 Market

It might be reasonable to expect that between holiday seasons the demand for PlayStation 5s could begin to wane — but the overheads of operating a retail electronics outlet remain consistent. When business is slow and with the tax season approaching, there could be an opportunity to squeeze the retailers for their precious PlayStation 5 inventory. Consider this: in a market that’s not as buoyant, the urgency to maintain cash flow might compel some retailers to turn to the cash offers in our re-imagined version of eBay, and this is where a discerning trader finds their niche.

Imagine then, strategically acquiring PlayStation 5s from these retailers when they’re most eager to sell. The real opportunity unfolds as the year progresses towards December, a time traditionally marked by a surge in demand, often driven by parents seeking to fulfill holiday wishes.

Now suppose that you could refuse delivery on the PlayStations you acquire and can instead opt to warehouse them free-of-charge in eBay’s depots. Then, after each transaction your eBay page immediately and automatically lists the console you just bought with more optimistic holiday season prices. Later, when you find a buyer at your asking price, the cash you receive immediately goes back on your eBay page, again offering cash for PlayStation 5s at a lower bidding price, in cycles, ad infinitum.

This is not as absurd as you might think. This practice of taking both sides of a market simultaneously, and the profit motive for doing so, is the business of professional market makers, typically large financial institutions or firms. However, in our context, both with respect to the PlayStation 5 on eBay and exchange primitives for cryptocurrency tokens on a blockchain, the scaled-down version of professional market making is nearly indistinguishable from the business of a pawn broker. I concede that the scale, regulatory environment, and nature of transactions (individual consumer goods vs. standardized financial instruments) are quite different, but the profit mechanism is literally identical:

Offer cash at a bidding price for something while
simultaneously offer the thing you are bidding on at a higher asking price.

I know it sounds trite — but there really is only one way to make money trading: Buy Low, Sell High, Repeat. It’s all there is, it’s all we’ve got, it’s not complicated, and it never was. Whether it is buying and selling PlayStation 5s on eBay via the warehousing method described above or providing token liquidity to a decentralized exchange, the financial fundamentals are indistinguishable. And I can prove it.

Using eBay as an Automatic Market Maker for PlayStation 5s

The canonical automatic market maker hasn’t changed at all since its inception in 2017. Its most familiar form is the one consisting of exactly two assets with equal portfolio weights, also known as the “constant product” or the xy = k pricing algorithm. This is the context where most DeFi users will have first encountered the concept of a “fee”; the common understanding is that use of their liquidity incurs additional charges from market participants, which accumulates to the value of their portfolio. Unfortunately, this description completely obfuscates the true nature of their activities. There is no such thing as a “fee” on a decentralized exchange, any more than there is on eBay. In fact, there is nothing stopping us from re-creating the xy = k AMM on our improved version of eBay (i.e. delivery refusal, warehousing, and the ability to list cash in exchange for goods).

For this exercise, we will begin with a PlayStation 5 inventory of 100 units, and $158,000 AUD in cash. Assume that the mid-market price for a new console is $1,580.00 AUD, and that we acquired all consoles in the inventory at this price. Using the xy = k pricing algorithm with a δ term of 0.2 (aka the “fee” parameter; 0.2 is unusually high but it doesn’t matter here), we would list our first PlayStation 5 for $2,000 AUD, and we would list our first cash offer at $1,251.49 AUD. Meaning, we are offering to buy a PlayStation 5 from anyone who would wish to sell one to us for $1,251.49 AUD and, simultaneously, we are offering to sell a PlayStation 5 to anyone who wants one for $2,000 AUD, thereby achieving a bid-ask spread of $2,000.00 AUD — $1,251.49 AUD = $748.51 AUD. Those are just our highest bidding and lowest asking prices; we have 99 more consoles in our inventory and another $156,748.50 AUD in cash reserves with which to create a market:

Table 1: The PlayStation 5 xy = k AMM bids and asks table.

Due to a quirk of the xy = k pricing algorithm, the last PlayStation 5 in the inventory is priced at infinity dollars, and the second to last unit carries an asking price of more than a third of a billion dollars. However, our cash bids are limitless; the 5189th consecutive bid is the last time we offer the market more than $1.00 AUD for a PlayStation 5.

I have shown these rows for completeness’ sake only. It is obvious that some of these prices are absurd. If we limit our market making to the first five rows, then we would only need $6,042.47 AUD and five PlayStation 5s, which would emulate an “amplified liquidity” position (also known as “concentrated liquidity”), meaning that despite having significantly less inventory and cash reserves, it continues to behave as though it contains 100 units and $158,000 AUD with respect to the xy = k model. The amplified version simply restricts the available market depth to whatever cash and inventory is provided without affecting the bidding and asking prices. Therefore, with fewer resources you could service the same market — provided it doesn’t overwhelm your bidding and asking prices. The DeFi community has somewhat misleadingly co-opted the term “capital efficiency” to describe this behavior, perhaps to invoke ideas of financial growth and profitability. “However, it can be inferred from its usage that the appropriation of the term in DeFi specifically compares one pricing model to another:

One pricing model is more capital efficient than another if
by default it offers higher bidding prices and lower asking prices
normalized to the same inventory and cash balances.

Figure 9: xy = k AMM PlayStation 5 bidding and asking depth.

Figure 10: Concentrated AMM PlayStation 5 bidding and asking depth.

Since our eBay store is adopting the prototypical Concentrated AMM pricing model, it is important to acknowledge that as the market takes PlayStation 5s from our inventory (i.e. as our asking prices are taken), our cash reserves are increasing, but also our bidding prices are updated. In a continuous liquidity situation the spread between the marginal bid and ask is a constant proportion, and is simple to calculate:

However, since customers are expecting to transact in whole PlayStation 5s, instead of fractions of a PlayStation 5, we will need to correct for price slippage, which in turn requires the relative amplification of our inventory to be appropriately accounted for (i.e. the reduced slippage of the concentrated position):

where:

x is the remaining PlayStation 5 inventory,
x₀ is the initial PlayStation 5 inventory (i.e. 5, in this example),
δ is the [unhelpfully named] “fee” parameter, in our case set to 0.2, and
A is the amplification coefficient, in this case 100/5 = 20.

Again, this is not difficult. I am aware that an equation or two may inspire fear and anxiety for many — but hear me out; all we are doing is establishing the rules for our eBay page(s) that:

adjust the bidding prices up as buyers take our PlayStation 5 market;
adjust the asking prices down as sellers take our cash market.

This gets easier with illustration. Suppose that after setting up our five asking prices and five bidding prices (Table 1) we make our first transaction: a PlayStation 5 seller takes our highest bidding price; our PlayStation inventory increases by one and we lose $1,251.49 AUD from the cash reserves. The other cash listings are unaffected; the next highest bid remains at $1,229.40. However, as the newly acquired PlayStation 5 is added to our store inventory, not only is it appended to the existing asks, but every single asking price is also adjusted according to the general spread formula.

Table 2: The PlayStation 5 bids and asks table after taking the first bid.

Figure 11: Updates to the asking depth after taking the first bid.

Assume that the PlayStation 5 seller’s appetite continues to increase, and they begin to accept the lower bidding prices, until there is only 1 PlayStation 5 left in the inventory.

Table 3: The PlayStation 5 bids and asks table after taking the first four bids.

Figure 12: Updates to the asking depth after taking the first four bids.

At this stage, all we have done is acquire four additional PlayStation 5s at an average of cost of $1,218.95 AUD per unit. Note that the model here is 1:1 with an AMM on the blockchain, save for some minor implementation-specific details. We listed five PlayStation consoles at five different prices, and four of them were bought. As a specialist PlayStation 5 pawn broker on eBay, and equally, as a token liquidity provider to a decentralized exchange, there are only two things you care about:

The acquisition costs and
the sale price,
not necessarily in that order.

This is the critical realization, and what I believe to be the most thoroughly misunderstood concept in all DeFi: the question as to what the fee earnings are up to this point. The short answer is that there is no fee; liquidity providers to AMMs do not charge fees, and so the “fee earnings” calculation is devoid of meaning. A better question — one which is more founded in financial reality, is whether the trading strategy is profitable. The answer is that before we can claim to have turned a profit, we need to sell the PlayStation 5 inventory back to the market at a higher price than it was acquired for.

That is really all there is to this. Bid low on PlayStation 5s when sellers are getting anxious and ask high when the market demand is increasing. There is no other profit mechanism.

Suppose that sometime after the market takes most of our cash reserves, the nine PlayStation 5s we have listed start to receive some interest. Then, finally, a PlayStation 5 buyer takes our lowest asking price; our PlayStation inventory decreases by one and our cash reserves recover by $1,862.82 AUD. The other PlayStation 5 listings are unaffected; the next lowest ask remains at $1,904.02 AUD. However, as the cash comes in, it is immediately added to cash listings and the bidding prices are updated according to the general spread formula. This is the exact reverse of the situation where our cash market was being taken.

Table 4: The PlayStation 5 bids and asks table after taking the first ask.

Figure 13: Updates to the bidding depth after taking the first ask.

Assume that interest in the PlayStation 5 market continues to develop, and buyers begin to accept the higher asking prices until there are only four PlayStations left in the inventory.

Table 5: The PlayStation 5 bids and asks table after taking the first five asks.

Figure 14: Updates to the bidding depth after taking the first five asks.

There is exactly one correct way to evaluate the performance of this trading strategy, and there is nothing subjective about it:

We started with $13,942.47 AUD in cash,
exchanged $7,900.00 AUD for five PlayStation 5s at the mid-market rate ($1,580.00 AUD), then
used the remaining $6,042.47 AUD to set up a cash market on eBay for an additional five consoles, while
simultaneously making the market for PlayStation 5s starting at an asking price of $2,000.00 AUD.
We acquired four additional consoles at an average price of $1,218.96 AUD per console, then
sold five consoles at an average price of $1,947.93 AUD.
The final balance sheet is $10,906.28 AUD in cash, and
four PlayStation 5s with a combined nominal value of $8,143.20 if we trust the last unit sale price,
culminating in a portfolio value of $19,049.48 and an unrealized profit of $5,107.01 (36.6%).

Note that the profit here is still unrealized. The starting cash balance was $13,942.47 and we still only have $10,906.28 in reserve. The four unsold consoles are still an outstanding liability until their value is consolidated back into Australian Dollars.

This is literally everything you ever needed to know about providing liquidity to a market — be it for PlayStation 5s, or via the ETH/USDC liquidity pool on your favourite AMM. My ambition with this illustration is not only to demonstrate that the common understanding of the “fee” parameter on an AMM is dangerously removed from reality, but also to bring attention to the fact of the matter — liquidity provisioning is a trading strategy. There is no ambiguity, no benefit of the doubt, nothing is left to interpretation.

Some things simply are, regardless of how we feel about it.

The Hubris of the Defeated

As with the misappropriation of the term “capital efficiency”, use of the term “toxic flow” (image related) in DeFi has become all but meaningless. That is not to say that toxic flow is not a real phenomenon — it absolutely is, and its effects range from a market nuisance to financial devastation. I’d like to extend my appreciation to the original author of Toxic Order Flow on theforexgeek.com for providing some much needed clarity, and from whom I have paraphrased the following bullets regarding what constitutes legitimate toxic order flow.

Spoofing: This involves a trader placing an order without any intention of letting it execute. Their goal is to falsely signal strong demand or supply, manipulating the asset’s price. After the price shifts favorably, they retract their order, capitalizing on this artificial movement.
Layering: Like spoofing, layering consists of setting up several orders at varied price points. This creates an illusion of significant trading activity, swaying the asset’s price. The trader then withdraws these orders, benefiting from the resultant price shift.
Marking the Close: Here, a trader executes a substantial order at or near the market’s closing time. This strategy aims to affect the closing price, which can also misrepresent the asset’s demand or supply, influencing its price.
Order Stuffing: This tactic involves flooding the market with numerous orders in a brief timeframe. The overload can cause processing delays and disrupt the normal pricing of the asset.
Front Running: In this scenario, a trader exploits advance knowledge of an impending order. By acting on this information, they position themselves to profit from the price changes that will follow once the large order is executed.
Insider Trading: This is trading based on confidential, non-public information. For instance, a company insider might buy stock before a positive announcement, aiming to sell it post-announcement for a profit.

In contrast, the concept of toxic flow in DeFi is, for lack of a better description, an imagined external tormentor that is summoned by those who end up on the losing side of bad trade (by providing liquidity to it). It is a convenient scape goat for bad businesses who get upset when they exit from their PlayStation 5 inventory only to see those same units for sale the following day at mark-up. Or, conversely, the pawn brokers who bought those PlayStations only to find that it is impossible to flip them for a profit later.

I speculate that there is, in fact, a good reason for this term to have entered the DeFi vocabulary in the context of AMMs and liquidity provisioning. Consider that despite my best efforts to make the material presented here as accessible as possible, for many DeFi users the subject matter is simply not interesting (no judgement!). My suspicion is that the people that belong to this category share a significant part of their Venn Diagram with those who don’t understand why their LP positions are losing money. Armed with only the dangerous half-knowledge afforded them by the paid shills on Twitter and YouTube, failure to perform financially could seem deeply mysterious. Together with the common misconception that losses on an LP position can be partially or wholly attributed to the actions of arbitrageurs, a crowd-sourced vision of the bogeyman on whom we can pin our accusations of unfair practices does emerge.

But this is a mistake.

The analysis in the previous section is perfectly valid on its own and does not require any additional context. In short, your trading profits and losses are what they are, irrespective of the motivations that drive eBay’s buyers and sellers to trade with you. The true toxic flow is not from those who interacted with a market you created — it is from those who would prefer the convenience of selling you on the idea of “capital efficiency” and “fees” and then never explain to you what either of those things really mean.

Conclusion

In this examination, the tangible case of eBay’s PlayStation 5 market has been utilized to elucidate the financial principles underlying liquidity provision in Automated Market Makers (AMMs). This analysis, while comprehensive and perhaps somewhat technical, demonstrates that these concepts are accessible to individuals engaging with DeFi primitives on the blockchain.

The DeFi sector is often characterized by the use of marketing buzzwords and emotive narratives. While these elements play a role in fostering enthusiasm and driving adoption, they can also veil the true nature of the financial decisions inherent in these protocols. An examination of eBay’s market dynamics offers a clear parallel to the activities of DeFi liquidity providers, particularly in the context of market making and pawn brokering. The fundamental principles of buying low and selling high are universally applicable, transcending specific claims about the uniqueness of any given protocol, regardless of its tokenomics.

The notion of ‘toxic flow’, frequently misunderstood or misapplied in the context of DeFi, is critically assessed. It is often cited as a rationale for losses in unfavorable trades or as a placeholder for a user’s misunderstanding of the pricing algorithm to which they are subscribed. In contrast, traditional market manipulations such as spoofing, layering, and insider trading represent genuinely toxic activities, though they are not typically the focus when ‘toxic flow’ is discussed within DeFi circles.

As the DeFi industry progresses, it becomes essential to engage with target audiences under the premise that they seek to remain informed and critical. Rapid and efficient user onboarding processes should not eclipse the responsibility of protocol developers to offer adequate resources for self-education to those of reasonable intelligence. The aim of this article is to demonstrate that the financial theories underpinning DeFi exchange primitives are straightforward enough that the lack of basic understanding among many users is somewhat inexplicable and we, the industry leaders, should have a plan to address that.

The emergence of DeFi has introduced a wave of marketing language that is both creatively enthusiastic and, in many cases, ultimately devoid of substance. Terms that once held well-defined meanings, such as “capital efficiency”, “fees”, “loss versus rebalancing”, and “toxic flow”, have become embroiled in the hubris of DeFi’s marketing hive mind. It is conspicuous that much of the industry’s success can be attributed to social media, where appeals to emotion and the distinctly human desire to be a member of the tribe are the primary focus. Consequently, it should come as no surprise that very simple financial concepts have taken on unnecessary ambiguity as communities in DeFi repurpose them to attract more tribe members. In this context, the precise communication of a financial concept becomes secondary to its emotional and social resonance.

Moreover, a notable aspect of this dynamic is the attitude of the DeFi users themselves. There is a discernible demand for access to sophisticated financial protocols, coupled with a resistance to engaging with the educational efforts necessary to use these tools effectively. Users often seek the benefits of DeFi participation without investing the time to understand the underlying principles. This paradoxical expectation has led to a form of communication within the DeFi space that prioritizes social engagement and often deliberately overlooks the more substantive, albeit less glamorous, foundational aspects of DeFi protocols.

The irony is that, while mundane, the underlying concepts are not at all challenging. However, I suspect that the added level of abstraction afforded by their context inside of the blockchain narrative can make it difficult to see the forest for the trees. To strip away the layers of ambiguity and social influence standing in the way of what should be accessible knowledge, I am going to focus on a more comfortable and practical analogy: the eBay market for the PlayStation 5 Blu-Ray Edition. This comparison with respect to the “Buy It Now” feature for merchants on eBay is quite nearly perfect; however, for the bidding prices we are going to take some poetic license by imagining a restructuring of eBay that, quite frankly, would bring some interesting new functionality to their platform. This approach aims to offer a more objective understanding of the core principles of exchange protocols, untangled from the tribalism and postmodern subjection of the communities that wield them.

The PlayStation 5 (Blu-Ray Edition) eBay Market

I am deliberately constraining the scope of eBay’s market for PlayStation 5’s (on the maker side) to something relatively straight-forward. I have no intention of aggregating this in any meaningful sense; the objective of this discussion is to arrive at a useful understanding of blockchain exchange primitives, not to embark on a thorough investigation of secondary consumer electronics markets. To collect a homogenous sample, I am focusing on the Blu-Ray Edition for the sole reason that there are more of them.

Figure 1: eBay PlayStation 5 market search.

I checked each listing to confirm that it was what it claimed; in some cases the disc drive needed to be selected from a dropdown menu to get the correct quote price. At least half of these listings are bundled together with a game. Anecdotally, whether a game is included with the bundle has zero correlation with the unit price. For each listing I recoded the quote and shipping value, and the number of units still for sale. There were two instances where a purchase of more than one console resulted in a discounted price on a per-unit basis. For these I assumed buying all the listed stock, thereby achieving the maximum discount. In another two instances, the number of units for sale was simply listed as “more than ten”. In these cases, I recorded the number of units as 11 and moved on.

Figure 2: Typical eBay PlayStation 5 seller’s page.

The PlayStation 5 (Blu-Ray Edition) eBay Depth Chart

Imagine that we live in a world where market takers (i.e. people buying PlayStation 5s) are rational, and consistently make good decisions. Completely divorced from reality though this may be, it is a necessary concession when analyzing the available market. We therefore assume that when interacting with the market, all else being equal, the taker will elect to purchase the most inexpensive PlayStation 5 first. After the transaction is made, that stock is removed from the marketplace. If there are more units available at the same price, the next consumer is unaffected; however, if the stock at the lowest price is depleted, then the next consumer is forced to interact with the next available unit at whatever its listing price is.

This situation is absolutely within the grasp of everyone using DeFi:

There are a limited number of PlayStation 5s on the market.
They are spread out over a range of asking prices by vendors.
If you want to buy a PlayStation 5, it is sensible to buy one at the lowest available
asking price.
After all the PlayStation 5s available at a single price point are consumed,
the next available asking price will be greater than the one that was just exhausted.

It is reasonable to ask how much retail business the PlayStation 5 market on eBay can sustain at a certain price level, or all price levels. To investigate, imagine buying each PlayStation 5 listed on eBay one by one, beginning from the lowest listing price and working your way up. As you perform each transaction, record the listing price for the PlayStation 5 you just bought, and the running total of all the money you have spent purchasing them. The plot of this data is called a market depth chart.

The eBay PlayStation 5 market depth is an important characteristic, because it reports how much the asking price of a PlayStation 5 is likely to increase given a surge in consumer demand. For example, imagine that you were tasked with buying a bunch of PlayStation 5s for Santa Claus to deliver to well-behaved human offspring at Christmas. Santa’s instructions are that you can only purchase a PlayStation 5 if it costs $1,200.00 AUD or less. From the chart below, you can tell immediately that you are going to spend $131,126.32 AUD buying PlayStations (including postage!); although, since the depth is reported in dollars it is not immediately clear precisely how many PlayStations you are buying. All you know is that after you are done, the first available price to the next consumer will be >$1,200.00 AUD. Therefore, market depth charts are more concerned with cash flow than the commodity it is paired with.

Again, I posit that this is not a challenging concept for DeFi users:

From examination of the depth chart, we can conclude that:
a purchase of $131,126.32 AUD worth of PlayStation 5s from eBay will
move the asking price from $720.95 AUD to > $1,200 AUD,
(i.e. > +66.45%).

Figure 3: eBay PlayStation 5 asking depth.

The PlayStation 5 (Blu-Ray Edition) eBay Bonding Curve

To determine how many PlayStation 5s will be adorning the televisions of deserving children (within budget), we can simply plot the loss of PlayStation 5 inventory by eBay merchants as a function of the increase in their cash balances. The starting PlayStation 5 inventory is 181 units, and the remaining inventory as the collective cash balance of the merchants approaches $131,126.32 AUD is 54 units; therefore, only 181–54 = 127 special children are receiving a PlayStation 5 for Christmas.

Figure 4: eBay PlayStation 5 asking bonding curve.

This kind of plot has become known as a “bonding curve” throughout DeFi. Notice that in this form the price data is sacrificed, so by itself is not especially useful. However, paired with the depth chart, the two together provide a phenomenally detailed snapshot of the current market. That is, assuming you are considering buying a suspicious quantity of PlayStations from eBay in a short timeframe. This is an important point: these kinds of analyses assume that you are buying all units at once before the vendors have time to react. If you are buying PlayStation 5s one-at-a-time, slowly over the course of hours or days, it is reasonable to expect that the vendors might move their prices up in anticipation of the oncoming demand. This kind of market reaction does not apply to AMMs, and so is outside the scope of the discussion.

While Santa’s instructions were to only purchase PlayStation 5s under the predicate that each one cost $1,200.00 AUD or less, we have still only spent a total of $132,126.32 AUD and acquired 127 consoles, which is an average of $1,032.49 AUD per unit. If we interpret Santa’s instructions to mean that we should spend no more than an average of $1,200.00 AUD per PlayStation 5, then we can afford to take the entire PlayStation 5 market at an average price per unit of $1,096.02 and still be under budget.

While this is a more common depiction in DeFi, I suspect that it is still a source of confusion for many:

The bonding curve is a plot of the eBay merchant’s PlayStation 5 inventory versus their cash balances.
As PlayStation 5s are sold, they are removed from the inventory (i.e. -ΔPlayStation 5)
and $AUD is added to the cash balance (i.e. +ΔAustralian Dollars).
The average price per PlayStation 5 when buying multiple units is simply the total units received from the vendor divided by the total cash paid.

The eBay We All Deserve but Can’t Have

As it stands, eBay allows consumers to interact with vendors in a variety of ways.

The most common is the situation already explored in the previous section, where vendors list their PlayStation 5s with specific asking prices, and consumers can browse the available asking prices before deciding to purchase.
Long ago, the most common interaction was via the auction mechanic, where the vendor provides the item and consumers bid against each other.
The third and final supported interaction is where the vendor may elect to accept offers — meaning that the item is listed with a certain asking price, but the consumer can negotiate a lower price.

Imagine a fourth mode of interaction, where consumers could list their cash with the “price” being an item they wish to purchase. Distinct from the third type of interaction, instead of offering cash to only the vendors who have elected to allow price negotiations, you could offer cash to all vendors, simultaneously. Such a system would align well with free market ideals; allowing consumers to list cash offers could lead to a more competitive and efficient market for PlayStation 5s.

Figure 5: Imagined eBay PlayStation 5 bidding page.

While this fourth type of interaction is currently absent (eBay, if you are reading this — call me), the auction component of the system for which they were once known is still alive and well, albeit much less popular than it was in its glory days. The auction mechanics are recorded and apparently freely auditable directly via the page wherein an auction is taking place (although, a login is required). I expanded the scope of the PlayStation 5 market probe to include those listings currently being actively bid on, and scraped their bidding history to get an idea of what the other side of the market might look like, were those without a PlayStation allowed to offer their cash directly to those with one, on their own terms.

Figure 6: Typical eBay PlayStation 5 bidding history.

I didn’t spend a huge amount of time on this — nor could I if I wanted to. At the time of writing there were only five relevant auctions, and only two of them were being bid on, and only by 12 different users. The other three auctions had their commencing bids (i.e. the one requested by the merchant) set well out of the money with respect to the market already available, which explains the lack of activity. Regardless, I collected 30 data points that represent individual prices that users had expressed an interest in transacting at. Never mind that we are demonstrably double counting the cash market; just pretend that each bid was from a unique user and that their offers were posted as listings on eBay proper, instead of being asked to compete for the same items in a live-auction format.

Thus, we can construct a depth chart as we have previously, but this time on the bids side. Imagine selling PlayStation 5s into this market, where consumers are offering cash via an eBay listing. Start by selling your PlayStation 5 inventory, one by one, beginning from the highest available bidding price and working your way down. As with the previous exercise, as you perform each transaction, record the bidding price for the PlayStation 5 you just sold and the running total of all the cash you have collected from consumers in the process. Since PlayStation 5 sellers taking this market are motivated to get the highest price, the bidding depth chart is mirrored relative to the asking depth chart; the market depth to sell PlayStation 5s improves as we approach lower prices.

Nothing surprising or difficult here, either:

There are a limited amount of cash offers on the market.
They are spread out over a range of bidding prices by consumers.
If you want to sell a PlayStation 5, it is sensible to sell it at the highest available bidding price.
After all the cash offers at a single price point have been taken,
the next available bidding price will be less than the one that was just exhausted.

This depth chart may be of interest if you have a large stockpile of PlayStation 5s, as it reports how much cash you could obtain quickly if you had to liquidate your inventory. For example, imagine you are tasked with liquidating Santa’s reserves of PlayStations after the United States Department of Justice charges him with wire fraud, money laundering, and conspiracy thereof. Your instructions are to not relinquish any PlayStations for less than $600.00 AUD apiece. Again, the depth chart self-reports that you will be able to liquidate $7,054.50 AUD worth of consoles, but it doesn’t tell you how many consoles that equates to.

To determine how many PlayStation 5s will be unloaded onto the market, we can simply plot the loss of Australian Dollars by consumers as a function of function of their increase in PlayStation 5s. Consumers begin with $16,673.50 in bidding liquidity, and their PlayStation 5 inventory approaches 10 as we take $7,054.50 AUD of their market. Therefore, we can afford to liquidate 10 PlayStation 5s without selling one beneath the $600 per unit mandate. As before, if we interpret our instructions as meaning an average of $600 AUD per unit, we can afford to take $12,725.95 of the cash market for an average of $606.00 AUD per console.

Figure 7: eBay PlayStation 5 bidding depth.

Figure 8: eBay PlayStation 5 bidding bonding curve.

Taking Both Sides of eBay’s PlayStation 5 Market

It might be reasonable to expect that between holiday seasons the demand for PlayStation 5s could begin to wane — but the overheads of operating a retail electronics outlet remain consistent. When business is slow and with the tax season approaching, there could be an opportunity to squeeze the retailers for their precious PlayStation 5 inventory. Consider this: in a market that’s not as buoyant, the urgency to maintain cash flow might compel some retailers to turn to the cash offers in our re-imagined version of eBay, and this is where a discerning trader finds their niche.

Imagine then, strategically acquiring PlayStation 5s from these retailers when they’re most eager to sell. The real opportunity unfolds as the year progresses towards December, a time traditionally marked by a surge in demand, often driven by parents seeking to fulfill holiday wishes.

Now suppose that you could refuse delivery on the PlayStations you acquire and can instead opt to warehouse them free-of-charge in eBay’s depots. Then, after each transaction your eBay page immediately and automatically lists the console you just bought with more optimistic holiday season prices. Later, when you find a buyer at your asking price, the cash you receive immediately goes back on your eBay page, again offering cash for PlayStation 5s at a lower bidding price, in cycles, ad infinitum.

This is not as absurd as you might think. This practice of taking both sides of a market simultaneously, and the profit motive for doing so, is the business of professional market makers, typically large financial institutions or firms. However, in our context, both with respect to the PlayStation 5 on eBay and exchange primitives for cryptocurrency tokens on a blockchain, the scaled-down version of professional market making is nearly indistinguishable from the business of a pawn broker. I concede that the scale, regulatory environment, and nature of transactions (individual consumer goods vs. standardized financial instruments) are quite different, but the profit mechanism is literally identical:

Offer cash at a bidding price for something while
simultaneously offer the thing you are bidding on at a higher asking price.

I know it sounds trite — but there really is only one way to make money trading: Buy Low, Sell High, Repeat. It’s all there is, it’s all we’ve got, it’s not complicated, and it never was. Whether it is buying and selling PlayStation 5s on eBay via the warehousing method described above or providing token liquidity to a decentralized exchange, the financial fundamentals are indistinguishable. And I can prove it.

Using eBay as an Automatic Market Maker for PlayStation 5s

The canonical automatic market maker hasn’t changed at all since its inception in 2017. Its most familiar form is the one consisting of exactly two assets with equal portfolio weights, also known as the “constant product” or the xy = k pricing algorithm. This is the context where most DeFi users will have first encountered the concept of a “fee”; the common understanding is that use of their liquidity incurs additional charges from market participants, which accumulates to the value of their portfolio. Unfortunately, this description completely obfuscates the true nature of their activities. There is no such thing as a “fee” on a decentralized exchange, any more than there is on eBay. In fact, there is nothing stopping us from re-creating the xy = k AMM on our improved version of eBay (i.e. delivery refusal, warehousing, and the ability to list cash in exchange for goods).

For this exercise, we will begin with a PlayStation 5 inventory of 100 units, and $158,000 AUD in cash. Assume that the mid-market price for a new console is $1,580.00 AUD, and that we acquired all consoles in the inventory at this price. Using the xy = k pricing algorithm with a δ term of 0.2 (aka the “fee” parameter; 0.2 is unusually high but it doesn’t matter here), we would list our first PlayStation 5 for $2,000 AUD, and we would list our first cash offer at $1,251.49 AUD. Meaning, we are offering to buy a PlayStation 5 from anyone who would wish to sell one to us for $1,251.49 AUD and, simultaneously, we are offering to sell a PlayStation 5 to anyone who wants one for $2,000 AUD, thereby achieving a bid-ask spread of $2,000.00 AUD — $1,251.49 AUD = $748.51 AUD. Those are just our highest bidding and lowest asking prices; we have 99 more consoles in our inventory and another $156,748.50 AUD in cash reserves with which to create a market:

Table 1: The PlayStation 5 xy = k AMM bids and asks table.

Due to a quirk of the xy = k pricing algorithm, the last PlayStation 5 in the inventory is priced at infinity dollars, and the second to last unit carries an asking price of more than a third of a billion dollars. However, our cash bids are limitless; the 5189th consecutive bid is the last time we offer the market more than $1.00 AUD for a PlayStation 5.

I have shown these rows for completeness’ sake only. It is obvious that some of these prices are absurd. If we limit our market making to the first five rows, then we would only need $6,042.47 AUD and five PlayStation 5s, which would emulate an “amplified liquidity” position (also known as “concentrated liquidity”), meaning that despite having significantly less inventory and cash reserves, it continues to behave as though it contains 100 units and $158,000 AUD with respect to the xy = k model. The amplified version simply restricts the available market depth to whatever cash and inventory is provided without affecting the bidding and asking prices. Therefore, with fewer resources you could service the same market — provided it doesn’t overwhelm your bidding and asking prices. The DeFi community has somewhat misleadingly co-opted the term “capital efficiency” to describe this behavior, perhaps to invoke ideas of financial growth and profitability. “However, it can be inferred from its usage that the appropriation of the term in DeFi specifically compares one pricing model to another:

One pricing model is more capital efficient than another if
by default it offers higher bidding prices and lower asking prices
normalized to the same inventory and cash balances.

Figure 9: xy = k AMM PlayStation 5 bidding and asking depth.

Figure 10: Concentrated AMM PlayStation 5 bidding and asking depth.

Since our eBay store is adopting the prototypical Concentrated AMM pricing model, it is important to acknowledge that as the market takes PlayStation 5s from our inventory (i.e. as our asking prices are taken), our cash reserves are increasing, but also our bidding prices are updated. In a continuous liquidity situation the spread between the marginal bid and ask is a constant proportion, and is simple to calculate:

However, since customers are expecting to transact in whole PlayStation 5s, instead of fractions of a PlayStation 5, we will need to correct for price slippage, which in turn requires the relative amplification of our inventory to be appropriately accounted for (i.e. the reduced slippage of the concentrated position):

where:

x is the remaining PlayStation 5 inventory,
x₀ is the initial PlayStation 5 inventory (i.e. 5, in this example),
δ is the [unhelpfully named] “fee” parameter, in our case set to 0.2, and
A is the amplification coefficient, in this case 100/5 = 20.

Again, this is not difficult. I am aware that an equation or two may inspire fear and anxiety for many — but hear me out; all we are doing is establishing the rules for our eBay page(s) that:

adjust the bidding prices up as buyers take our PlayStation 5 market;
adjust the asking prices down as sellers take our cash market.

This gets easier with illustration. Suppose that after setting up our five asking prices and five bidding prices (Table 1) we make our first transaction: a PlayStation 5 seller takes our highest bidding price; our PlayStation inventory increases by one and we lose $1,251.49 AUD from the cash reserves. The other cash listings are unaffected; the next highest bid remains at $1,229.40. However, as the newly acquired PlayStation 5 is added to our store inventory, not only is it appended to the existing asks, but every single asking price is also adjusted according to the general spread formula.

Table 2: The PlayStation 5 bids and asks table after taking the first bid.

Figure 11: Updates to the asking depth after taking the first bid.

Assume that the PlayStation 5 seller’s appetite continues to increase, and they begin to accept the lower bidding prices, until there is only 1 PlayStation 5 left in the inventory.

Table 3: The PlayStation 5 bids and asks table after taking the first four bids.

Figure 12: Updates to the asking depth after taking the first four bids.

At this stage, all we have done is acquire four additional PlayStation 5s at an average of cost of $1,218.95 AUD per unit. Note that the model here is 1:1 with an AMM on the blockchain, save for some minor implementation-specific details. We listed five PlayStation consoles at five different prices, and four of them were bought. As a specialist PlayStation 5 pawn broker on eBay, and equally, as a token liquidity provider to a decentralized exchange, there are only two things you care about:

The acquisition costs and
the sale price,
not necessarily in that order.

This is the critical realization, and what I believe to be the most thoroughly misunderstood concept in all DeFi: the question as to what the fee earnings are up to this point. The short answer is that there is no fee; liquidity providers to AMMs do not charge fees, and so the “fee earnings” calculation is devoid of meaning. A better question — one which is more founded in financial reality, is whether the trading strategy is profitable. The answer is that before we can claim to have turned a profit, we need to sell the PlayStation 5 inventory back to the market at a higher price than it was acquired for.

That is really all there is to this. Bid low on PlayStation 5s when sellers are getting anxious and ask high when the market demand is increasing. There is no other profit mechanism.

Suppose that sometime after the market takes most of our cash reserves, the nine PlayStation 5s we have listed start to receive some interest. Then, finally, a PlayStation 5 buyer takes our lowest asking price; our PlayStation inventory decreases by one and our cash reserves recover by $1,862.82 AUD. The other PlayStation 5 listings are unaffected; the next lowest ask remains at $1,904.02 AUD. However, as the cash comes in, it is immediately added to cash listings and the bidding prices are updated according to the general spread formula. This is the exact reverse of the situation where our cash market was being taken.

Table 4: The PlayStation 5 bids and asks table after taking the first ask.

Figure 13: Updates to the bidding depth after taking the first ask.

Assume that interest in the PlayStation 5 market continues to develop, and buyers begin to accept the higher asking prices until there are only four PlayStations left in the inventory.

Table 5: The PlayStation 5 bids and asks table after taking the first five asks.

Figure 14: Updates to the bidding depth after taking the first five asks.

There is exactly one correct way to evaluate the performance of this trading strategy, and there is nothing subjective about it:

We started with $13,942.47 AUD in cash,
exchanged $7,900.00 AUD for five PlayStation 5s at the mid-market rate ($1,580.00 AUD), then
used the remaining $6,042.47 AUD to set up a cash market on eBay for an additional five consoles, while
simultaneously making the market for PlayStation 5s starting at an asking price of $2,000.00 AUD.
We acquired four additional consoles at an average price of $1,218.96 AUD per console, then
sold five consoles at an average price of $1,947.93 AUD.
The final balance sheet is $10,906.28 AUD in cash, and
four PlayStation 5s with a combined nominal value of $8,143.20 if we trust the last unit sale price,
culminating in a portfolio value of $19,049.48 and an unrealized profit of $5,107.01 (36.6%).

Note that the profit here is still unrealized. The starting cash balance was $13,942.47 and we still only have $10,906.28 in reserve. The four unsold consoles are still an outstanding liability until their value is consolidated back into Australian Dollars.

This is literally everything you ever needed to know about providing liquidity to a market — be it for PlayStation 5s, or via the ETH/USDC liquidity pool on your favourite AMM. My ambition with this illustration is not only to demonstrate that the common understanding of the “fee” parameter on an AMM is dangerously removed from reality, but also to bring attention to the fact of the matter — liquidity provisioning is a trading strategy. There is no ambiguity, no benefit of the doubt, nothing is left to interpretation.

Some things simply are, regardless of how we feel about it.

The Hubris of the Defeated

As with the misappropriation of the term “capital efficiency”, use of the term “toxic flow” (image related) in DeFi has become all but meaningless. That is not to say that toxic flow is not a real phenomenon — it absolutely is, and its effects range from a market nuisance to financial devastation. I’d like to extend my appreciation to the original author of Toxic Order Flow on theforexgeek.com for providing some much needed clarity, and from whom I have paraphrased the following bullets regarding what constitutes legitimate toxic order flow.

Spoofing: This involves a trader placing an order without any intention of letting it execute. Their goal is to falsely signal strong demand or supply, manipulating the asset’s price. After the price shifts favorably, they retract their order, capitalizing on this artificial movement.
Layering: Like spoofing, layering consists of setting up several orders at varied price points. This creates an illusion of significant trading activity, swaying the asset’s price. The trader then withdraws these orders, benefiting from the resultant price shift.
Marking the Close: Here, a trader executes a substantial order at or near the market’s closing time. This strategy aims to affect the closing price, which can also misrepresent the asset’s demand or supply, influencing its price.
Order Stuffing: This tactic involves flooding the market with numerous orders in a brief timeframe. The overload can cause processing delays and disrupt the normal pricing of the asset.
Front Running: In this scenario, a trader exploits advance knowledge of an impending order. By acting on this information, they position themselves to profit from the price changes that will follow once the large order is executed.
Insider Trading: This is trading based on confidential, non-public information. For instance, a company insider might buy stock before a positive announcement, aiming to sell it post-announcement for a profit.

In contrast, the concept of toxic flow in DeFi is, for lack of a better description, an imagined external tormentor that is summoned by those who end up on the losing side of bad trade (by providing liquidity to it). It is a convenient scape goat for bad businesses who get upset when they exit from their PlayStation 5 inventory only to see those same units for sale the following day at mark-up. Or, conversely, the pawn brokers who bought those PlayStations only to find that it is impossible to flip them for a profit later.

I speculate that there is, in fact, a good reason for this term to have entered the DeFi vocabulary in the context of AMMs and liquidity provisioning. Consider that despite my best efforts to make the material presented here as accessible as possible, for many DeFi users the subject matter is simply not interesting (no judgement!). My suspicion is that the people that belong to this category share a significant part of their Venn Diagram with those who don’t understand why their LP positions are losing money. Armed with only the dangerous half-knowledge afforded them by the paid shills on Twitter and YouTube, failure to perform financially could seem deeply mysterious. Together with the common misconception that losses on an LP position can be partially or wholly attributed to the actions of arbitrageurs, a crowd-sourced vision of the bogeyman on whom we can pin our accusations of unfair practices does emerge.

But this is a mistake.

The analysis in the previous section is perfectly valid on its own and does not require any additional context. In short, your trading profits and losses are what they are, irrespective of the motivations that drive eBay’s buyers and sellers to trade with you. The true toxic flow is not from those who interacted with a market you created — it is from those who would prefer the convenience of selling you on the idea of “capital efficiency” and “fees” and then never explain to you what either of those things really mean.

Conclusion

In this examination, the tangible case of eBay’s PlayStation 5 market has been utilized to elucidate the financial principles underlying liquidity provision in Automated Market Makers (AMMs). This analysis, while comprehensive and perhaps somewhat technical, demonstrates that these concepts are accessible to individuals engaging with DeFi primitives on the blockchain.

The DeFi sector is often characterized by the use of marketing buzzwords and emotive narratives. While these elements play a role in fostering enthusiasm and driving adoption, they can also veil the true nature of the financial decisions inherent in these protocols. An examination of eBay’s market dynamics offers a clear parallel to the activities of DeFi liquidity providers, particularly in the context of market making and pawn brokering. The fundamental principles of buying low and selling high are universally applicable, transcending specific claims about the uniqueness of any given protocol, regardless of its tokenomics.

The notion of ‘toxic flow’, frequently misunderstood or misapplied in the context of DeFi, is critically assessed. It is often cited as a rationale for losses in unfavorable trades or as a placeholder for a user’s misunderstanding of the pricing algorithm to which they are subscribed. In contrast, traditional market manipulations such as spoofing, layering, and insider trading represent genuinely toxic activities, though they are not typically the focus when ‘toxic flow’ is discussed within DeFi circles.

As the DeFi industry progresses, it becomes essential to engage with target audiences under the premise that they seek to remain informed and critical. Rapid and efficient user onboarding processes should not eclipse the responsibility of protocol developers to offer adequate resources for self-education to those of reasonable intelligence. The aim of this article is to demonstrate that the financial theories underpinning DeFi exchange primitives are straightforward enough that the lack of basic understanding among many users is somewhat inexplicable and we, the industry leaders, should have a plan to address that.

The PlayStation 5 eBay Market

The PlayStation 5 eBay Market

The PlayStation 5 eBay Market

Mark Richardson

Mark Richardson

Mark Richardson

The PlayStation 5 (Blu-Ray Edition) eBay Market

The PlayStation 5 (Blu-Ray Edition) eBay Depth Chart

The PlayStation 5 (Blu-Ray Edition) eBay Bonding Curve

The eBay We All Deserve but Can’t Have

Taking Both Sides of eBay’s PlayStation 5 Market

Using eBay as an Automatic Market Maker for PlayStation 5s

The Hubris of the Defeated

Conclusion

The PlayStation 5 (Blu-Ray Edition) eBay Market

The PlayStation 5 (Blu-Ray Edition) eBay Depth Chart

The PlayStation 5 (Blu-Ray Edition) eBay Bonding Curve

The eBay We All Deserve but Can’t Have

Taking Both Sides of eBay’s PlayStation 5 Market

Using eBay as an Automatic Market Maker for PlayStation 5s

The Hubris of the Defeated

Conclusion

The PlayStation 5 (Blu-Ray Edition) eBay Market

The PlayStation 5 (Blu-Ray Edition) eBay Depth Chart

The PlayStation 5 (Blu-Ray Edition) eBay Bonding Curve

The eBay We All Deserve but Can’t Have

Taking Both Sides of eBay’s PlayStation 5 Market

Using eBay as an Automatic Market Maker for PlayStation 5s

The Hubris of the Defeated

Conclusion

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