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

CryptoLabs Research | Crypto Passive Income | Defi

6 Aug 202404:35

Summary

TLDRThis 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.

Outlines

00:00

📊 Understanding Nonlinear Payoffs in Liquidity Pools

The speaker introduces the concept of nonlinear payoffs for liquidity providers, explaining that unlike holding an asset spot, liquidity pools have a concave or negatively convex payoff. This means that as a liquidity provider (LP), one experiences greater losses when the asset's value decreases and smaller gains when it increases, compared to simply holding the asset. Despite this, providing liquidity can be profitable due to the passive income generated from fees, especially in sideways markets where holding the asset alone would yield no returns.

💰 Maximizing Profitability: Why Choose Liquidity Pools?

The speaker discusses why liquidity providers might choose to participate in liquidity pools despite the downside risks. They highlight that the fees earned as a liquidity provider can significantly outweigh the benefits of simply holding an asset, especially when the market is stable. For example, holding ETH might yield no profit over a month if its price doesn't change, but being in an LP position could generate 10% or more in fees during the same period.

🔒 Hedging Risks in Liquidity Pools

The speaker delves into strategies for hedging the downside risks associated with the concave payoff of being a liquidity provider. They discuss the importance of eliminating Delta risk—directional risk—so that the provider is only exposed to earning fees. This involves transforming the concave payoff structure into one where the primary concern is only the potential for moving out of range to the upside.

📉 How to Achieve a Delta-Hedged Position

The speaker explains a strategy for creating a Delta-hedged or Delta-neutral position using a method developed by Overnight Finance. This involves borrowing a volatile asset like ETH against a stable asset, which creates a short position. By pairing the borrowed ETH with stable assets in an LP position, the speaker explains how this setup allows the LP to be hedged against price declines, as both the LP position and the debt decrease in value, balancing out the risk.

📈 Managing Upside Risk in Delta-Hedged Positions

In this section, the speaker addresses how to manage the risk of large upside moves when using a Delta-hedged strategy. They emphasize the importance of daily rebalancing the hedge to avoid liquidation. The speaker suggests keeping a reserve of collateral assets or actively managing the hedge to maintain a Health Factor of 1.2 or above, following the successful approach used by Overnight Finance. This ensures that the position remains stable and profitable despite market fluctuations.

Mindmap

Keywords

💡Hedging

Hedging refers to the strategy of reducing risk by taking an offsetting position in a related asset. In the context of the video, hedging is used to manage the downside risk associated with a liquidity pool (LP) position, ensuring that if the value of the underlying asset decreases, the potential loss is minimized or neutralized.

💡Liquidity Pool (LP)

A Liquidity Pool (LP) is a collection of funds locked in a smart contract, used to facilitate trading on decentralized exchanges. In the video, providing liquidity in an LP results in a nonlinear payoff, meaning the returns are not directly proportional to the price movement of the underlying asset. The speaker discusses the implications of this nonlinearity and how to hedge associated risks.

💡Nonlinear Payoff

A Nonlinear Payoff is a return structure where the relationship between the asset's price movement and the profit or loss is not a straight line. In the video, the LP position has a nonlinear payoff, described as concave or negatively convex, meaning that losses increase more on the downside and gains are lower on the upside compared to holding the asset directly.

💡Delta Neutral

Delta Neutral refers to a strategy where the overall portfolio is hedged so that small changes in the price of the underlying asset do not affect the portfolio's value. The video explains how to create a delta-neutral position in a liquidity pool, where the directional risk is eliminated, allowing the provider to earn fees without exposure to price movements.

💡Concave Payoff

A Concave Payoff refers to a situation where the potential loss is greater on the downside than the potential gain on the upside. In the video, the LP position is described as having a concave payoff, meaning that providing liquidity could result in greater losses if the asset's price decreases, compared to the gains if the price increases.

💡Stablecoin

A Stablecoin is a type of cryptocurrency that is pegged to a stable asset, such as a fiat currency, to minimize price volatility. In the video, the strategy involves lending a stablecoin and borrowing a volatile asset like ETH to create a delta-neutral LP position. The stability of the stablecoin helps in managing the risk of large price movements.

💡Borrowing

Borrowing in this context refers to taking out a loan of a volatile asset like ETH against a stable asset. The borrowed asset is then used in an LP position to hedge against price movements. The video explains how borrowing ETH and pairing it with stablecoins in an LP can help in creating a delta-neutral position, protecting the provider from downside risk.

💡Yield

Yield refers to the income generated from an investment, typically in the form of interest or fees. In the video, the yield is the passive income earned from providing liquidity in a pool, which can be significant even if the underlying asset's price remains stable. This yield is a key incentive for participating in liquidity pools despite the associated risks.

💡Rebasing

Rebasing in this context means adjusting the position to maintain a specific balance or health factor, such as a 1.2 health factor mentioned in the video. This process ensures that the LP position remains safe from liquidation during significant price movements. The speaker emphasizes the importance of daily rebasing to manage the risks associated with large price spikes.

💡Health Factor

The Health Factor is a metric used to assess the safety of a leveraged position in DeFi. It is a ratio that indicates the risk of liquidation; a higher health factor means lower risk. In the video, maintaining a health factor above 1.2 is crucial to avoid liquidation in the delta-neutral strategy, especially during volatile market conditions.

Highlights

Introduction to hedging and liquidity pools, explaining the difference between linear and nonlinear payoffs.

Explanation of the concave or negatively convex payoff when providing liquidity compared to holding an asset spot.

Clarification that liquidity providers lose more to the downside and gain less to the upside compared to holding the asset.

Discussion on the profitability of providing liquidity due to passive income from fees, despite the nonlinear payoff.

Illustration of how holding ETH while it moves sideways results in no gain, but providing liquidity can generate significant fees.

Introduction to the concept of hedging downside risk in a liquidity provider (LP) position to eliminate Delta risk.

Description of a strategy to hedge downside risk by borrowing a volatile asset against a stablecoin.

Explanation of how borrowing against a stablecoin creates a classic short position, profiting from a decline in the borrowed asset's value.

Step-by-step guide on pairing borrowed ETH with stablecoins to create an LP position that is Delta hedged.

Clarification that in this Delta hedged position, a decline in ETH's value reduces both the LP position's value and the debt value, balancing the loss.

Identification of the risk to the upside in a Delta hedged position, where both the LP position's value and the debt value increase.

Introduction to strategies for protecting against significant upside moves, including daily rebalancing of the hedge.

Discussion on maintaining a 1.2 Health Factor to avoid liquidation, as practiced by Overnight Finance.

Explanation of how Overnight Finance keeps a reserve of collateral assets as a precaution against large spikes to the upside.

Conclusion on creating a Delta hedged or Delta neutral position to manage risk in liquidity provision.