June 3, 2022
The economics of providing liquidity in AMM protocols like Uniswap are simple: receiving fees for taking the risk of impermanent losses (IL). The strategy is profitable as long as fees can more than cover the losses.
Fees are affected by trading volumes and TVL which are unknown a priori. IL depends on volatility and price swings which can pose significant risks as we saw during the Terra/Luna rout. Both fees and IL are moving numbers, making it difficult for liquidity providers (LPs) to predict profitability. For example, in April this year, quiet markets and depressed volumes hurt LPs’ income while in May, the crash and increased volatility inflicted heavy impermanent losses.
This suggests that AMM yield farming has a heavy amount of luck involved with the two key risks to the LP being:
1) Low trading volume driven by range bound markets and so fewer transaction volumes and so less fees and;
2) Large market moves in either direction which result in significant impermanent loss.
Is there a way to lock fees or IL at a level known in advance so that yield farming is not the pure luck of the draw?
Fortunately, there is. In our previous 2 articles, “The Ultimate Solution to Overcome Impermanent Loss”, “Protecting Your Assets in AMM Pools in This Choppy Market”, we introduced an IL protection product whereby liquidity providers pay a predetermined premium at the start and will be reimbursed for the IL at the end. By doing this, LPs transfer the entire IL risks to OrBit and can focus on optimizing fee incomes without having to worry about IL. Readers can subscribe to our Telegram bot to get live IL pricing: https://t.me/orbit_IL_bot.
How about the other way around, i.e. lock the fees at the start against the risk of a decrease in trading volumes? Yes, OrBit can offer such a fee protection product as well. Here is how it works:
Liquidity providers agree on a fee level with OrBit and stake liquidity with OrBit instead of an AMM pool. At maturity, OrBit return the liquidity to LPs, plus the pre-agreed fee, and minus any IL incurred based on the IL formula. (see appendix for the formulas)
Let’s look at a concrete example. A liquidity provider plans to provide liquidity in Uniswap V3 ETH-USD pool over the price range [1600, 2400] for 30 days with 1 million USD. Instead of actually injecting capital in Uniswap, she could stake the capital with us, and earn a guaranteed fee of 4.95% (APY 80%), minus any impermanent loss incurred after 30 days. If the spot fell from 2000 to 1800, the IL would be 1.37%, net she would receive 4.95% - 1.37% = 3.58% over 30 days, or an APY of 53%.
The benefits of such a fee protection product are obvious:
- Fee income is locked and known in advance, unaffected by adverse changes in trading volumes and TVL.
- Same risk exposure as providing liquidity in Uniswap
- Potentially higher yields than actually providing liquidity in Uniswap
On the last point, Guillaume Lambert wrote an excellent article “On-chain Volatility and Uniswap v3”, in which he proposed a way to estimate Uniswap implied volatility. The Uniswap implied volatility of ETH-USD is currently between 44% and 49% (see screenshot below) whereas liquid option markets price it at 75%~80%. This creates an arbitrage opportunity. By taking exactly the same risks, LPs can potentially earn more fees via OrBit’s fee protection product than actually providing liquidity in Uniswap.
The table below shows guaranteed fees on ETH-USD for various durations and price ranges (priced as of 24 May 2022). If a LP estimated that it would be difficult to generate more fees than indicated in the table, then she would be better off buying a fee protection product which effectively benefits from the higher implied volatility available in CeFi option markets.
How can OrBit lock the fees?
As a group of experienced derivatives traders, we use our advanced quant models and risk engines to synthetically replicate the Uniswap exposure via a calibrated portfolio of vanilla options, which is then dynamically rebalanced to maintain a predetermined fee target. OrBit actively uses Paradigm, with its large network of market makers and zero fee policy in order to facilitate trading and rebalancing the vanilla option portfolio.
Appendix - IL formulas
OrBit is an institutional liquidity provider of crypto exotic options and structured products. Our services include structuring, pricing, trading and market making. Founded by a team of experienced leaders in derivatives trading and computer engineering, and backed by Matrixport and BH Digital, OrBit brings its deep know-how in OTC options and structured products to the crypto market. We serve organisations across CeFi, DeFi and TradFi looking for more sophisticated investment and risk management solutions in digital assets.
Paradigm is an institutional liquidity network for crypto derivatives traders and crypto protocols across both CeFi and DeFi ecosystems. The platform provides traders and crypto protocols unified access to multi-asset, multi-protocol liquidity on demand without compromising on execution preferences, costs and immediacy. The firm’s mission is to create a platform where traders can trade anything, with anyone and settle it anywhere.
Paradigm has the largest network of institutional counterparties in crypto with over 700 institutional clients trading over $10B per month including Hedge Funds, OTC Desks, Lenders, Structured Product Issuers, Market Makers, and prominent Family Offices.