[Strategy Paper] Hedged Liquidity Providing in Swaps (1/4)

Providing liquidity to swaps like Uniswap or Balancer is not new but it only received sufficient market attention in this year’s defi bull run. For instance, Uniswap was launched in November 2018, after receiving several grants as well as $100,000 from the Ethereum Foundation. Before August this year, it’s TVL was about 100m in total but soon reached 3b in its peak a few months later.

​Other leading swaps are Balancer, Sushiswap (Uniswap’s fork), Curve (stablecoin and btc swaps), etc. The more ancient ones are like Bancor and Kyber, but they did not seem to gain much fame and AUM this summer.

​Compared to centralised exchanges (CEX) like Binances, the swaps (also called Automated Market Markers, a.k.a AMM) fees of 0.25% to 0.3% seem to be high. On binance, the rate is 0.075% and discounts are given to holders of BNB and large volume traders. AMMs offer mainly three competitive advantages: first, its slippage will be lower, if the pool for a particular token is large enough. In CEX, the slippage caused by bid-ask spread can be high at times and lack of volume sometimes give additional uncertainty about this. AMMs address this issue by offering an immediate, calculated price slippage based on the pool size; and when the pool is large, arguably the slippage is smaller than the bid-ask spread in the CEX.

Secondly, there’s custodian issues for AMMs, and users of AMMs just need to operate their wallets like Metamask and do not need to deposit their tokens into a CEX. In early days, CEX got hacked quite often and today CEX is still the target of regulatory bodies. Bitmex was sued in US and OKEX’s founder was seized by the Chinese police.

Thirdly, swaps, as the basic lego blocks of the entire Ethereum ecosystem, form an indispensable part of many on-chain tools and programs, like arbitraged trading, automatic mining vaults, futures and options, insurance, etc. For instance, Yearn receives deposits from investors in DAI and deposits into Curve, claims CRV rewards and sells back to DAI via Uniswap, and deposits the DAI back to Curve for reinvestments. Such compounded investments will not be possible, if there’s a CEX step in between and need manual operations.

In a nut shell, AMM swaps do offer an alternative to CEX and it’s volume are genuine reflections of changes in the industry — how people trade and exchange tokens. We take the long-term view that as the Ethereum ecosystem is getting more robust, more activities will be carried on-chain and this will benefit AMM swaps. More volumes will take place on-chain, and this attracts more liquidity, further lowering the slippage (and potentially transactions fees). This is a virtuous cycle as long as the crypto industry and Ethereum are growing healthy.

We will be analysing the investment merits in each of these platforms’ tokens (in an equity investment sense), but for the purpose of this article series, we will explain only how to earn a passive income from AMM swaps.

The below table gives our calculated hedged returns on 10 Uniswap pairs, as a liquidity provider.

​Please follow our Medium account to read more about how we have derived at these returns.

(Serenity Team, 27 Nov 2020)