Polygon & API3 Space: The Potential of Oracles to Extract Value

About a year ago, API3 introduced a method that allows DeFi applications to start reclaiming millions of dollars leaked due to oracles, known as oracle-extractable value (OEV). OEV is supported by Polygon Labs CDK and is based on ZK Rollup. Today, the Polygon DeFi team, along with the API3 team, explores how to unlock the potential of oracle-extractable value.

【Guests Present】

Justin: Head of Growth at Polygon DeFi.

Jack: Head of BD at Polygon DeFi.

JoeB Grech: Marketing at API3, responsible for API3's marketing campaigns.

API3 (official account): Core member of the technical team.

Ben: Head of the API3 ecosystem, responsible for expanding to new chain partners and working within the CDK system to ensure all different components can be utilized.

Kevin: Primarily responsible for the upcoming OEV product.

Patrick: Content creator focused on educational and informative content about DeFi.

【Question 1】

Justin: Can you share your thoughts on the challenges in the Polygon ecosystem, the concept of oracle-extractable value, etc.? Please elaborate on the concept of oracle-extractable value and its significance in the current DeFi landscape.

Jack: Let me briefly explain what OEV is. Whenever there is a price change on-chain, it can potentially trigger a liquidation event. For example, if the price of ETH drops from $4,000 to $3,500, the price is updated by the oracle. Anyone who is long leveraged on a perpetual exchange or anyone using leverage in the lending market could be liquidated if the value of their collateral falls below the maintenance level. Once this happens, the liquidation event creates an opportunity to generate profit. This forms MEV arbitrage or liquidation, which typically incurs liquidation fees ranging from 5% to 20% in the lending market.

The end result is that the oracle price will be pushed on-chain, triggering a liquidation after internal updates, and then the liquidation will trigger events that smart contracts can invoke, allowing bots to call the counterparties to facilitate the liquidation.

Bots are essentially only responsible for putting up capital; they can capture the entire spread. But this also means a lot of value is passed on to these MEV or liquidation bots. For API3, the oracle-extractable value is that it will be passed on to the dApp itself, which can choose to pass it on to users, who can use it to increase yields or for other purposes, whatever they may be. In the OEV world, it is the liquidation bots that update prices, rather than waiting to see those prices pushed on-chain and then bidding to create liquidation events.

The only ones truly capturing value are the bots and the validators who earn Gas from the liquidation. However, validators will lose earnings in the OEV network because bots will not pay high Gas fees to validators to be the first liquidator; instead, they will pay fees to the application itself. In this case, API3 will become the API that pushes price updates on-chain because they are the ones pushing price updates on-chain. They have the capability to actually handle welfare markets or lending exchanges or any other form of liquidation.

This is very similar to sandwich attacks and MEV arbitrage, where the amount the arbitrageurs are willing to pay is to extract the final value. For many specific types of applications, it actually just creates a channel for incremental revenue, which is very meaningful for many large platforms like this.

Justin: That's great. Does anyone else have anything to add?

Kevin: One thing to add is how simple this actually is for the applications using it. I think if you dive into the seeker side and what they have to do to reclaim this MEV.

But from the dApp's perspective, you don't really have to worry about any of that. It takes about 7 minutes, depending on your architecture, but you really don't have to worry about anything. You just set up the API3 data source and the address to extract funds.

【Question 2】

Justin: What do you think are the current drawbacks in the lending liquidation space, particularly around MEV extraction related to liquidations, and what is the correlation between traditional liquidation MEV and oracles?

Kevin: I think different projects have different motivations for liquidating loans. As Jack mentioned, you will see liquidation ratios between 5% and 20%. This is one way some of these projects generate revenue. For example, they have 5% of funds flowing to liquidators, and then with each liquidation, they also allocate 5% of funds to the protocol. So, it’s not new to see these people viewing liquidation as a form of cash flow. For OEV, a lot of the profits are very thin, and with these liquidation incentives, they return the rewards to the seekers. Seekers will pay up to 99% of the liquidation incentive so they can take the opportunity to earn 1%. Therefore, seekers are willing to spend a little to do this.

For OEV to reclaim 99% of the protocol, they can implement a burn mechanism, they can lower interest rates. They can do a variety of things with it, and when you can make these small improvements to your product and help your users out of a bind and make your product more competitive overall when you are facing off against different lending dApps, these small changes can have a huge downstream impact.

API3: Block producers do bring a lot to the ecosystem because they are the ones building the blocks. But they earn too much money from MEV, and then the incentives become misaligned because ideally, block builders shouldn’t be earning most of their money from MEV; they should be earning from building blocks.

But regardless of that fact, currently, block builders offer sorting options for every block they build. Seekers can bid for the right to be first in that block, and they need to do this for the first liquidator, as these liquidations are profitable. The simplest way to put it is bribery, bribing the block builders. Typically, this is 90% to 95% of the value of the liquidation incentive. What we are trying to achieve with the OEV network is to conduct auctions at the block builder level and then execute those auctions in an open, decentralized, and censorship-resistant trustless environment.

【Question 3】

Patrick: Based on our discussion with OEV, I want to say that my biggest question so far is that I am struggling to think about how much value this can actually bring. Do they have any case studies or simulations to illustrate how much value can actually be captured?

API3: There are tens of millions every year. So that number is huge and will only grow with bull markets and how growth is defined. I think we will release a tool. Hopefully, by this weekend, it will help you see how much validators and seekers are earning, and you can manipulate it by entering your own parameters.

Kevin: Our price feeds will update on-chain data, where the data is based on a deviation called 1% deviation. Then, seekers will monitor the OEV network, and it will be updated every second. So it becomes more granular and timely. When seekers see a price that will trigger an application liquidation, they just need to bid and win the right to use the latest dynamically updated on-chain price. This will trigger the liquidation. So it’s just a layer above our regular price sources, making them more refined. It provides another layer of redundancy where people can execute these liquidations. It just offers a better oracle product on top of that. Then you can make money. The integration actually requires nothing; you don’t need to do any work at all. I think, at this level, the foundation of the product is much better than many products people are currently using, especially if they are using price pushers.

Justin: This is very revolutionary and extremely exciting. Also, why would seekers want to connect to the OEV network for liquidations?

API3: One of the other reasons we want to do this is twofold: why specifically choose zk-rollup over something like op-rollup? It’s because we need seekers to bridge funds onto the network to be able to bid, and op-rollup has a 7-day withdrawal period, which is not ideal.

This is where zk-rollup shines, and the CDK is actually quite revolutionary for the AG layer because seekers do not need to keep funds on the CDK. Once the bidding fee is paid, or once they win the bid, it will then be paid to the network participants. Then seekers will receive price updates for winning that bid. They can use that price update to liquidate on any chain we operate.

Kevin: For seekers, there’s not much persuasion needed to get them to do this. Because first, it’s really easy. I’m a terrible developer. It took me a few hours to spin up a bot to do this, but others can do it in even less time. Second, if you want to win MEV, if you want to be a seeker and take advantage of these opportunities, you have to go through us; you have to participate to win.

【Question 4】

Justin: We have discussed how to search and liquidate with the OEV network. But how does it ensure fair and effective value capture and redistribution to dApps, especially across different blockchains? I think this might be part of the zk structure you are talking about, but can we delve deeper into this?

API3: Suppose you are a seeker, and you see a liquidation on Polygon; you deposit it into a contract within the OEV network, and then you can bid. The data source drops to the price you bid, and you will receive the right to update. The auction on the OEV network then returns to Polygon for price updates, and since the dApp's price has been updated, liquidation can occur, with the price update also being separately signed by oracle nodes.

【Question 5】

Justin: Which type of protocol do you think is most likely to adopt this OEV capture strategy? Is it lending or Dex? Who do you think will benefit the most?

Kevin: Primarily lending protocols, but I think perpetual contracts are the next major area. For most of them, it makes sense to do a lot of things with leverage.

【Question 6】

Justin: What do you think they should do with the reclaimed OEV? What opportunities are there? What benefits do these steps bring to the Polygon ecosystem and its users?

Kevin: We have several different ways to make things better. I think they can reduce slippage, mitigate the liquidation penalties that borrowers face due to liquidations, and incentivize them to take on more leverage and use leverage more. Protocols can use the reclaimed value for token buybacks and burns, with each different protocol set up slightly differently regarding their revenue sources and how all of this works.

But I think there are only small areas that can improve efficiency, where you can gain a slight edge when there are competitors doing exactly the same thing but not running OEV, forming a positive spiral and helping you generate more momentum for the entire protocol.

I think everyone will figure out where they want these gains to go, but I think the cumulative effect of more efficient products and the momentum created is the biggest advantage here.

【Question 7】

Justin: What else is on the roadmap for API3?

API3: For the roadmap, we have some other products in development. Our next focus is primarily on the OEV network. I think many lending protocols are very optimistic about OEV revenue and the story it brings because if you can capture your OEV revenue like the funds reclaimed from OEV and put it into your liquidity pool, it gives you a growth of 1-1.5%, which is already enough. Compared to your competitors, you will attract more TVL. I think seeing this story unfold and helping to deeply realize this story will be our mission this year.

With API3, we want to be the oracle solution you don’t need to go anywhere else for, and you should be able to do everything on any chain using API3 if you have oracle needs. This includes if you want to make API calls or capture OEV.

【Question 8】

Justin: I would like to hear any final thoughts or closing remarks from anyone. Perhaps there are other important things we didn’t get a chance to address, or you wish you had the opportunity to address now.

Ben: I think there may be some learning protocol opportunities within the Polygon community to attract users and drive growth within the ecosystem. I think this is indeed not the best point like collaborating with Venus, which would bring huge returns for them. But I think this will be very interesting in the short term.

Jack: I think OEV is a very interesting narrative. Because this situation will occur in the scale of oracles, generating incremental revenue at the protocol level is like icing on the cake. There’s no reason not to do it. Because you can effectively monetize what has already leaked value before.

Patrick: Capturing value and differentiating oneself has always been a deep battle. For me, OEV seems like a very compelling way for some of those applications to actually bring more value to the protocol, which they can then use to grow or distribute to users.