Nov 27, 2020
[Strategy Paper] Hedged Liquidity Providing in Swaps (2/4)
Let’s start with Uniswap.
The mechanism of Uniswap comprises of two groups of people: traders who use Uniswap to trade one cryptocurrneyc to another one; liquidity providers who provide funds in the pool, a pair of any two cryptocurrencies of equal total value, for trading to happen. Traders pay liquidity providers for a fee of 0.3% of the value transacted.
The set-up of Uniswap is very elegant. For more details, please refer Uniswap’s official guide here: https://uniswap.org/docs/v2/protocol-overview/how-uniswap-works
To earn passive income in Uniswap as a liquidity provider, we need to prepare two tokens of equal total value. For instance, if we think ETH-USDT pair has more people trading and it’s a good choice of investment, then we need to prepare 100 ETH and if price is $500 USDT/ETH today, 500 USDT. We deposit these into the USDT-ETH pool together.
Then we will join other liquidity providers, to receive a proportionate share of the trading fees of each transaction. On 26 Nov 2020, the 1-year Fees / Liquidity looked good (but usually its somewhere between 10% to 30%). Here liquidity means the USD value of both tokens in the pool provided by all liquidity providers. ETH-USDT is $157m now, and if we invest $157k (in equal shares of ETH and USDT), we will be entitled to 0.1% of the Fees of $403,163 for the last 24hours. That gives us a annualised return of 93.35%.
How much volume Uniswap’s trading pair generates a day is a matter of many factors, e.g. Market sentiments, demand for one particular token, special events, etc. For all Uniswap pairs, the trading fee is always 0.3% of the transacted value. We term it Basic Earnings in our calculation.
In addition, Uniswap gave rewards in its platform token UNI, for liquidity providers in certain pools. For some time this Sept till Nov, 20m UNI, worth about US$70m approximately, were rewarded to liquidity providers in the top 4 leading pools above. https://uniswap.org/blog/uni/ This translating into a Mining Rewards. The yield on the Mining Rewards depends on how much is the total liquidity in the pool. During the mining reward period, the liquidity in the top pools reached several hundred millions in each pool, and driving the annualised Mining Reward yield to 10% to 20%. CoinMarketCap gives a summary of the mining rewards for most of the platforms with mining rewards: https://coinmarketcap.com/yield-farming/ . Some platforms are inherently risky, so we do not consider them as investment targets; we will explain this in future articles.
For now, we recap that the yield of the liquidity provider in Uniswap is Basic Earning like trading fees plus the Mining Rewards. This is similar in other AMM swaps like Sushiswap or Balancer.
There’s cost of being a liquidity provider. First, there’s an inherent risk in the design of AMM swaps, name impernamanent risk. This risks arising from price movements from the point you entered into the liquidity pool, and it’s a cost regard the price direction of the two underlying tokens. In other words, there’s always an impermanent loss, as long as the price moves. For more technical details, please refer to https://academy.binance.com/en/articles/impermanent-loss-explained for details.
For now, we only need to know the scale of impermanent loss. If the relative price of the two underlying tokens in one pool moves 100% (thinking that if you provided ETH-USDT, and the price of EHT shoot up from 500 to 1000, or drop to 250), your total loss is 5.7%, compared to the case if you just hold on to the tokens and have not provided them into the Uniswap pool. Impermanent loss is both ways and only takes place when you withdraw the liquidity; it’s a point-of-time event and it cannot be hedged.
Arguably, impermanent loss is relatively small, if your holding period is long enough. Think that if ETH price go from 500 to 2500 or to 100, that gives you a loss of 25.5%, vs a potential earning of 30% in a year’s time. Prediction of price movement is very arbitrary. We use weekly standard deviation of the token prices in a pair to estimate impermanent loss.
Secondly, some investors, like us, do not want volatility. Whilst we cannot hedge impermanent loss, we can hedge the price movements of ETH. For doing so, we hedge the entire portion of ETH that we have invested into Uniswap, in Binance or Compound.
For Binancen hedging, which we currently use, is shorting ETH. If we have 100 ETH in Uniswap pools, we short 100 ETH in Binance. This has a few impacts: 1) this removes our exposure to ETH price fluctuations; 2) this consumes more capital, and thus reduces our overall returns; 3) this might be a cost or a gain to us, depending on the funding rates of Binance. We will explain the funding rates in Binance in another strategy paper.
For Compound hedging, we deposit USDT into Compound and borrow ETH. We will achieve the same results as compared to using Binance, except for that there’s always a cost (Compound borrowing rates for USDT).
Therefore, let’s re-cap that our cost of hedged liquidity providing is Impermanent Loss plus Cost of Hedging. And our return is Basic Earning plus Mining Rewards. The table below gives you a detailed breakdown on how we calculate (noting that for this time period, Uniswap mining rewards has been halted temporarily:
(Serenity Team, 27 Nov 2020)
