How to HEDGE your Liquidity Pools positions!? (Like Overnight Finance)

Summary

This video discusses the concept of liquidity pools and how they differ from holding assets in spot positions. The speaker explains the nonlinear payoffs in liquidity pools, where liquidity providers face more downside risk and less upside gain compared to holding assets directly. However, the potential for earning fees can make liquidity provision profitable. The speaker also covers strategies to hedge downside risk and maintain a delta-neutral position by borrowing assets and actively managing the hedge, using insights from Overnight Finance's approach.

Takeaways

• 📉 Nonlinear payoffs: Liquidity providers experience a concave or negatively convex payoff, losing more to the downside and making less to the upside compared to holding an asset spot.
• 💸 Importance of fees: Despite the nonlinear payoff, providing liquidity can be profitable due to the fees earned, especially when the asset price moves sideways.
• 🔄 Delta hedging: To mitigate downside risk and achieve a neutral position focused on earning fees, it's important to hedge against directional risks.
• 🧩 Strategy overview: A delta-hedged position can be created by lending a stablecoin, borrowing a volatile asset like ETH against it, and then using the borrowed asset to provide liquidity.
• 🔍 Classic short position: Borrowing a volatile asset like ETH against a stablecoin creates a short position, which profits if the asset declines in value.
• ⚖️ Balanced risk: In a delta-hedged LP position, both the value of the LP position and the debt fluctuate together, providing a natural hedge against downside risk.
• ⬆️ Upside risk: The main risk in this strategy is a significant upside movement of the volatile asset, which can increase the value of the debt and potentially lead to liquidation.
• 📊 Rebalancing: To manage this risk, it's crucial to regularly rebalance the hedge, ensuring the health factor stays above a certain threshold, like 1.2.
• 📈 Overnight Finance strategy: The approach described is inspired by Overnight Finance, which includes keeping a collateral reserve and actively managing the hedge.
• 🛡️ Delta-neutral goal: The ultimate goal is to create a delta-neutral position where the primary focus is on earning fees without directional risk.

Q & A

What is a nonlinear payoff in the context of providing liquidity?

A nonlinear payoff for liquidity providers means that their returns do not follow a straight line. Instead, they experience a concave or negatively convex payoff, where they lose more to the downside and make less to the upside compared to just holding the asset spot.

Why might liquidity providers lose more on the downside and make less on the upside?

Liquidity providers experience this because, when they deploy an asset into a liquidity pool, the value of their position is affected by both the asset's price movement and the nature of the pool, resulting in this concave payoff.

If liquidity providers lose more on the downside and gain less on the upside, why would they provide liquidity at all?

Liquidity providers are incentivized by the fees earned from their positions. These fees can outweigh the potential losses or reduced gains, especially if the asset price moves sideways and the provider still earns passive income from the pool.

How can liquidity providers hedge their downside risk in a liquidity pool?

To hedge downside risk, liquidity providers can use a strategy that involves borrowing a volatile asset like ETH against a stable asset. This borrowing creates a short position that profits if the asset declines, offsetting the losses in the liquidity pool.

What does it mean to be 'Delta hedged' in this context?

Being 'Delta hedged' means that the liquidity provider has eliminated their directional risk. If the asset price moves down, both the LP position and the debt decrease in value, balancing each other out. The provider's main concern then becomes managing the risk of a significant upward price movement.

What are the main risks when using the Delta hedging strategy?

The primary risk in this strategy is a significant upward price movement, which could increase the value of both the LP position and the debt, potentially leading to liquidation if not managed carefully.

How can liquidity providers protect against the risk of a significant upward price movement?

Liquidity providers can protect against this risk by regularly rebalancing their hedge, maintaining a reserve of collateral assets, or keeping their health factor at or above 1.2 to avoid liquidation.

What is the role of rebalancing in this strategy?

Rebalancing is crucial in maintaining the effectiveness of the hedge. By rebalancing, providers can adjust their positions to ensure that they remain protected against price movements, particularly to the upside.

Why is it important to maintain a health factor of 1.2 or above?

Maintaining a health factor of 1.2 or above helps prevent liquidation. It ensures that the provider's collateral remains sufficient to cover the borrowed asset, even in the event of significant price changes.

What is the advantage of using a strategy like the one described by Overnight Finance?

The strategy described by Overnight Finance allows liquidity providers to create a delta-neutral position, where they can earn fees without taking on directional risk. This makes the strategy appealing for those looking to minimize risk while still participating in liquidity provision.