Opinion: Uniswap V3 LP is essentially shorting volatility

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In the current high volatility stage of the market, Uniswap V3 liquidity providers will face greater risks.

Written by: Ian Wu, head of DFG pre-investment

summary:

  1. The author thinks that Uniswap V3 might be more suitable if it is changed to Uniswap PRO. My opinion is that V3 is not an upgraded version of V2, but a completely different attempt, and the two products should exist at the same time and occupy their respective markets.
  2. V3 is a very fascinating product, with some attributes similar to options, and even an option that the seller earns time income (Theta). For V3 researchers suggest adding some concepts about volatility.
  3. In the second half of the article, I share some ideas for setting up V3 LP trading with covered call/put options.
  4. Finally, there are some concerns about the accumulation of V3 liquidity.

V3 may be named Uniswap Pro

Uniswap V2 or the previously released Uniswap product is characterized by Pool to People or Open Finance. There is no essential difference between the user’s injecting 100 US dollars into the liquidity pool and the existing 1 billion US dollars of funds in the pool. Everyone gathers into a public market-making pool, and the fees earned by the pool are distributed to everyone according to the proportion of the provider. Participant. The efficiency of all funds is exactly the same, which solves the problem that long-tail assets can be exchanged for assets as long as there are quotes.

The liquidity aggregation design of V3 is completely different. The liquidity provision certificate has been changed to NFT Token. The reason is that each LP is set to be different from city to city and is non-standard. As a result, different intervals have different widths, and the efficiency of capital use varies. From the starting point, V2 is to provide whether the long-tail market can be exchanged, while V3 is more professional for improving capital use efficiency and lower slippage for professional products for head transactions with sufficient liquidity. Therefore, the author believes that V2 and V3 are two products with different positioning, which will continue to occupy different product positioning on DEFI instead of upgrading.

V3 features and volatility

Most of the views have stopped at discussing the quantitative characteristics of V3. Based on the previously shared views, this article will further discuss the relationship between V3 and volatility, as well as the views of market games. It is well known that V3 is replaced by interval liquidity aggregation for V2, and the process of setting intervals that runs out of the process of non-stop random fluctuations in prices will suffer greater gratuitous losses, as shown in the figure below.

Blue is the V3 interval curve, green is the V2 curve

So in essence, V3 is to compress the tolerance range of price fluctuations and reduce the liquidity segment interval to obtain the enhancement of capital use efficiency.

Viewpoint: Uniswap V3 LP is essentially shorting volatility

As shown in the figure above, the liquidity segment of the USDC/ETH trading pair V3: most of them are concentrated in the middle, which does show that the liquidity is concentrated near the market price. It reflects that V3 loses its resistance to price fluctuations in exchange for the efficiency of capital use.

In other words, V3 is essentially empty fluctuations in exchange for more royalties. Similar to option products, both sell volatility and get royalties.

About V3 and volatility

With the random fluctuation of the price, the transaction price gradually ran out of the set range, which will gradually increase the free loss and even make the trading pair only have one currency quilt. How to deal with it? Option sellers (market makers) will generally conduct dynamic hedging of their positions—continuous hedging as the price fluctuates back to near-neutral exposure.

V3 does dynamic hedging similar to options is to constantly adjust the LP NFT range following the price. Since every adjustment of LP NFT interaction on Ethereum requires a fee, it is not better to adjust LP NFT as much as possible. Then the optimal frequency of adjusting LP NFT is the V3 market-making fee income, and the real-time price fluctuations (free loss size) Balance between the three and the GAS cost.

Under the assumption that the V3 fee income is fixed, the higher the GAS fee, the less the number of adjustments, the better, the greater the price fluctuation, the more the number of adjustments, the better, so adjusting the frequency and size of LP NFT depends on the balance between price fluctuations and GAS costs of. In fact, GAS mainly changes with the fluctuation of ETH price. Although there are two dimensions of control, the balance of frequency and granularity, it is mainly affected by the volatility of ETH. Non-ETH trading pairs also need to additionally consider the exposure of ETH price fluctuations to the impact of GAS.

It can be seen from the above that the adjustment plan is still the source of the forecast of the (future) price volatility of the trading pair. In addition to the quantitative method of financial engineering for volatility forecasting (not expanded here), the short-term volatility can also be judged subjectively. For example, if ETH recently dropped from about 4000 to 3000 US dollars, if I assume that the author will subjectively judge about 3000, there will be inter-community shocks. This is actually my subjective prediction that the short-term volatility will return/decrease in the future. I choose to set 3000-3500 after falling. The market-making range between. If the market is consistent with the author’s assumption of subjective choice of opportunity, this hypothesis will get the benefits of doing things in this range.

This leads to another point of the author: V3 LP hedging scheme: quantitative volatility forecasting and subjective LP concept.

This is a new concept that is completely absent in static market making in V2, and both methods are Alpha. Different teams have different opinions. Therefore, the author believes that V3 is the first shot of subjective initiative Alpha income, which is the same as the static income of the whale.

Through the efforts of oneself or the team, one can increase their Alpha income, and increasing the utilization rate of funds is equivalent to obtaining a leverage from V3. In this way, projects based on the upper level of V3 belong to quantitative services or subjective transaction services rather than machine gun pools, and even run counter to the concept of machine gun pools. In addition, the author believes that V3-based service provider projects temporarily feel that a team with option experience will have more advantages, and projects similar to Charm are also being closely watched.

Practical V3 trading strategy

The concept of opportunistic LP was mentioned above, let’s demonstrate the application strategy of opportunistic LP.

Strategies similar to covered call (put) options

Let me briefly explain that a covered call option is a combination of having a spot in hand and setting a target price to sell (buy) the option. For example, I have 1ETH and want to sell it at 4500USD. Then I get 4500USD plus sell 4500USD call options. When the price reaches 4500 or higher, the buyer will take my ETH, and my income will be 4500USD + the option premium sold. For the planned purchase price of 4500, some gains have been enhanced.

It can be operated on V3. Assuming that the current market price of ETH is 3,500 US dollars, I want to sell ETH at 4,500 US dollars. I set the trading pair to be higher than the market price of 3,500 US dollars, such as 4250-4750. In this way, you only need to put in ETH. When the price fluctuates in the range of 4250-4750, you can get market-making income, and when the price is higher than 4250, ETH starts to be sold until it is sold out at 4750. (At this time, the average selling price is about 4500, which is not very rigorously calculated.) The total return should be about $4,500 unilateral + market-making income. (Here you can reduce the market-making range to get closer to 4500) Reach the predetermined take profit target and then withdraw the US dollar LP.

Viewpoint: Uniswap V3 LP is essentially shorting volatility

The bargain selling strategy and so on are shown below, which is to show the US dollar ordering strategy from about 2500 to 3000 near 2750. I will not repeat it here.

Viewpoint: Uniswap V3 LP is essentially shorting volatility

It is worth noting that, try to think about your subjective expectations before injecting liquidity, and avoid blindly injecting liquidity into your trading plan.

Strategies on the depth of the handicap

Mainly from the game of the market counterparty. Refer to the figure below, you can see that the depth is completely distributed on the right side of the market price. It is speculated that there are either a large number of LPs that have not had time to be replaced and remain in the previous range of about 4000, or a large number of LP holders believe that the price will return to about 4000. The latter kind of speculation is the opportunistic LP behavior of the subjective volatility judgment mentioned above. Looking forward to the gradual maturity of V3 LP market-making participants in the later period, it is speculated that the depth distribution of LP in the future will show a similar option holding situation, that is, most of the current market participates in the judgment of prices.

Viewpoint: Uniswap V3 LP is essentially shorting volatility

At the same time, the author’s concern is also raised here. Under the conditions of free game, due to the free and open market, irrational behaviors will occur. For example, the extreme narrowing of the price range will only consider market-making gains without considering volatility. Participants who do not fully understand the V3 features need to avoid being led by such blind behaviors to make erroneous judgments.

Concerns after liquidity accumulation

Regarding the liquidity aggregation of V3 innovation, the current characteristics of the main liquidity of V3 are concentrated in the market, which is very similar to the market-making situation of CEX. At this time, if there is a big volatility that impacts the market and eats up liquidity or when LP risk control chooses an opportunity, there may be a greater price slippage or stampede than V2.

Perhaps V3 is more suitable for almost no cost LP adjustment interaction on Layer 2 will be another scene to achieve the market-making price response speed of centralized exchanges.

Supplement: The price of ETH fluctuated about 3000-4000 US dollars when the coiner completed the first draft, and it had fallen below 3000 US dollars just before the publication. The market is currently in a period of very high volatility. Liquidity providers participating in V3 should always pay attention to changes in volatility to avoid losses.

Uniswap V3 demonstrates the leading innovation ability of the Uniswap team and the unlimited vitality of DeFi. In the open and free DeFi, the Alpha benefits brought by V3 will again be the salary fire that subverts the static income of whales. Leading scientists, market makers continue to optimize and create better income efficiency. Looking forward to the future, DeFi-based risk control, fixed interest rate and tiered funds and other different directions will try to divide DEFI into different Alpha and Beta income tracks. In DeFi, there will be different choices of risk and benefit ratios, and the era of “eating a big pot of rice” with all the same benefits will change.

Viewpoint: Uniswap V3 LP is essentially shorting volatility

Thanks to MaDao and Blanker for the research on the V3 machine gun pool and the early discussion together, and thanks to Mr. Lian Wenpan for his encouragement. Due to time constraints and insufficient research, please correct me.

Disclaimer: As a blockchain information platform, the articles published on this site only represent the author’s personal views, and have nothing to do with the position of ChainNews. The information, opinions, etc. in the article are for reference only, and are not intended as or regarded as actual investment advice.

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