Impermanent loss hedged LP • MEV Capital

Understanding liquidity provision in DeFi

Liquidity providers (LP) generate organic trading volume and fees from liquidity pools in decentralized exchanges. The yield generated from these pools represents meaningful market-making fees that LPs can capture.
Liquidity is provided in a range within which the LP earns fees. Outside this range, the LP position becomes idle and no longer earns fees until the price re-enters the range.
Liquidity provision can be thought of as analogous to a short gamma position. In both cases, the LP and the gamma seller suffer from significant moves in the underlying, while both are broadly rewarded in range-bound markets. Liquidity providers are rewarded through fees. Gamma sellers are rewarded by receiving an option premium.
Structural arbitrage and dislocation exist between on-chain LP and off-chain volumes. Option markets do not price fees that can be earned from Decentralised Exchanges yet.
The current market structure represents an opportunity as the current dislocation is expected to increase while off-chain volumes continue to become more competitively priced.

Example trade: hedged liquidity provision

Position open: Entry into a dynamic LP position on a specified price range (e.g., USDC/ETH: 1000/2500) on UniSwap DEX.
Hedge acquisition: The buyer acquires a combination of put & call options with the same maturity date and varying strike prices to hedge the LP position.
Yield generation: The buyer’s LP position generates trading fees while the price stays within specified boundaries. The tighter the range, the higher the yield.
Settlement: At maturity, the options contracts expire, and the position is settled with the OTC options desk to capture final P&L of the trade. The position can be priced again and rolled over if the renewed terms are acceptable to all parties.

Features and associated risks

Trades are short-dated (1/2 weeks) depending on market conditions. Yields are dependent on trading volumes while hedging costs are entirely dependent on the level and shape of the volatility surface.

Residual risk relies on risk management or the stop-loss at a lower bound.

Crypto-specific tail risks such as Smart Contract risk, underlying asset risk, or blockchain risk must be appreciated.

The contract carries short-duration counterparty risk of the entity providing OTC hedge.

IN WHICH UNDERLYING ASSETS ARE RETURNS GENERATED?

Impermanent loss-hedged LP positions can be opened (and generate returns) in USDC, ETH, or BTC, depending on the client’s preference.

IS THE STRATEGY FULLY MARKET-NEUTRAL?

The Impermanent loss-hedged LP product is market-neutral while the price remains in the specified range and assumes either a bullish or a bearish bias when the price exceeds the boundaries. In the bullish contract, the client can face losses on the notional amount, if the price goes below the lower bound. Alternatively, in the case of a bearish contract, notional can be negatively impacted, if the price goes above the higher bound.

IS IT POSSIBLE TO EXTEND THE PRODUCT MATURITY DATE?

The existing contract can be extended (re-rolled) weekly by recalibrating the product boundaries and bias. Product re-roll will change the APR due to changes in market volatility, updated product maturity, and new boundaries.

HOW CAN I MONITOR MY POSITIONS?

A client is provided with a trade monitoring dashboard that marks-to-market positions and accrued coupons daily. MEV Capital’s digital asset managers are available on demand via private communication channels set up with the client.