While Uniswap V3 improves the efficiency of market-making funds, it also greatly increases the impermanent losses that LPs may suffer.
Recommended reading: “Selected Chain News | Understanding Uniswap V3: A New Era of AMM Liquidity”
Original title: “Why Uniswap V3 greatly increases the market-making risk of LP? 》
Written by: Rhythm Research Institute
In the early days when Uniswap V3 went online, many LPs who joined the market making for V3 first enjoyed extremely high fee yields. But the good times did not last long. The entire crypto market suffered a sharp drop in prices in late May. Many V3 LPs found that their market-making positions not only turned into relatively lower-priced tokens in trading pairs, Moreover, the loss of the entire position in market fluctuations has increased significantly compared to that of market making in V2.
So, how does the risk taken by the LP of Uniswap V3 change compared to V2, and how should investors better understand this risk? This article hopes to start with the most basic principles of market-making activities and analyze what changes Uniswap V3 will bring to investors.
From liquidity provider to portfolio manager
How to treat “providing liquidity” objectively is an extremely critical issue. Becoming a liquidity provider (LP) of Uniswap, although you can get transaction fee income, but at the same time, you have to bear the risks of changes in the ratio of different currencies and changes in prices. Therefore, relying solely on the rate of return as the only indicator of investment decision-making obviously has serious flaws.
So, how can a more comprehensive assessment of the pros and cons of providing liquidity? Here, we recommend that participants switch to a new perspective to think about the whole problem. That is, the provision of liquidity is regarded as a portfolio management strategy adopted by investors.
This strategy, on the one hand, does not need to rely on the subjective judgment of the fund manager for human manipulation, on the other hand, it will dynamically adjust the proportion of investors’ positions based on market price changes and a fixed algorithm. This new type of portfolio management strategy that not only absorbs the essence of passively managed funds without manual intervention, but also combines a proactive position adjustment mechanism, we renamed it as “active passive asset management strategy.”
From this perspective, the former LPs will no longer be regarded as liquidity providers of trading platforms, but as investors who wish to preserve and increase the value of their assets. Then, the standard for evaluating whether it should become an LP will also change from a single market-making rate of return to the expected return of the investment portfolio, and the amount of risk that may be taken during the investment process.
So, what are the main risks that investors in this “active passive asset management” fund will face?
Impermanent loss and inventory risk
Choosing a reasonable performance evaluation benchmark is the most critical assumption for evaluating the risk and return of a certain investment portfolio. When we evaluate the risk-return situation of a credit bond, we can choose a treasury bond interest rate with no credit risk as the evaluation benchmark; when we evaluate an actively managed stock investment fund, we can choose a comprehensive index of the stock market over the same period. Generally speaking, the choice of which benchmark is used to evaluate investment performance mainly depends on the other best choices that investors have when they are not participating in this investment, which is what we often call “opportunity cost”.
So when evaluating this “fund” called LP Position, which indicator should investors choose as the evaluation benchmark?
Take the ETH-USDC trading pair as an example. For investors who are bullish on ETH, full position holding of ETH can be used as his evaluation benchmark; for investors who are short on ETH, holding all US dollars can be used as his evaluation benchmark; for the expected ETH price will not fluctuate significantly The investor who maintains the status quo and does not participate in market making can serve as his evaluation benchmark.
As a result, we have constructed the following four different investment strategies (the initial total amount is all 1,000 US dollars):
- 100% hold ETH
- 100% hold USDC
- 50% hold ETH, 50% hold USDC
- Use 50%ETH and 50%USDC to buy “LP Position Fund” to participate in market making
Without considering the handling fee, the vertical axis represents the end-of-period market value of the portfolio, and the horizontal axis displays the different ETH prices that may appear at the end of the period. We can make a functional image of the end-of-period market value of the above four portfolios at different ETH end-of-period prices.
It can be seen that if the ending price of ETH does not change relative to the beginning price (3000 USD), the ending market value of the four strategies will also remain unchanged (1000 USD). But if the price of ETH falls, strategy 2 (holding USD) is the optimal choice; if the price of ETH rises, strategy 1 (holding ETH) is the optimal choice.
It’s worth noting that if investors choose strategy 4 (green line), that is, use $1,000 to buy a fund called “LP Position” to participate in market making, then the market value of the fund at the end of the period will be in addition to the starting point of the price. It will always be below Strategy 3 (yellow line). And this part of the difference is what we often call “Impermanent Loss.” What is reflected in the impermanent loss is the fund called “LP Position”, which actively adjusts its positions during price changes, which is expected to bring additional losses to investors.
Let us return to the perspective of investors. Assuming that investor A expects the price of ETH to increase in the future, if it purchases the “LP Position” fund at the beginning of the period, what risks will investor A take when the price of ETH does rise?
Since Investor A has purchased the “LP Position” fund, it will bear the risk of impermanent loss caused by the fund when the price rises, that is, the difference between strategy 3 and strategy 4. At the same time, since its optimal strategy should be to hold ETH in a full position, it is 50% USDC exchanged for the purchase of the “LP Position” fund, and will not be able to enjoy the benefits of subsequent ETH rises, so this part of the position will be given to investor A Brings “inventory risk” loss, which is the difference between strategy 1 minus strategy 3.
Therefore, for investor A, the inventory risk brought to him by buying the “LP Position” fund market making will be far greater than the risk of impermanent loss. From this we can summarize the following conclusions:
- For investors who expect the price of ETH to rise, buying “LP Position” funds will make them bear great inventory risks. Therefore, the optimal strategy should be to stay away from market making activities and look for other ETH-based investment tools (such as participating in the Ethereum 2.0 PoS pledge activity).
- For investors who expect the price of ETH to fall, they should stay away from market making activities for the same reason, so as not to passively hold ETH and thus bear the inventory risk of its price fall. The optimal strategy should be to find stable currency-based financial management or mining activities.
- For investors who expect the price of ETH to remain stable, there is not much difference between holding ETH or USDC (because they expect little price fluctuations between the two). Therefore, it would be a good choice to use two currencies to purchase a certain “financial management product” to earn income.
However, we just mentioned that buying this kind of fund called “LP Position” has a negative net income relative to not buying it (the market value at the end of strategy 4 will always be less than strategy 3). So why should investors become LPs and make markets for trading platforms?
Handling fee is compensation for impermanent loss
In the above, in order to simplify the model, we ignored the impact of handling fees on the market value at the end of the period. Now let us reconsider the impact of handling fees and see how different strategies under real circumstances will bring about any changes to investors’ end-of-term market value.
We have found that when the handling fee is reconsidered, it makes sense to purchase “LP Position” funds to participate in market making. Because of the fee income as compensation, within a certain price range, the ending market value of strategy 4 (green line) is finally higher than strategy 3 (yellow line). Therefore, the logic for investors to purchase “LP Position” funds to participate in market making activities has also been clarified: in order to obtain a positive return within a period-end price range, investors have to bear the risk of loss after the end-of-period price fluctuation exceeds this range.
In other words, the prerequisite for participating in market-making activities to obtain positive returns is that investors expect that the asset price will not fluctuate sharply at the end of the period. Once the ending price of the asset exceeds the safe range, the investor’s investment portfolio will bear the corresponding risk of loss. This is why some people refer to market making with liquidity as “short volatility.”
Uniswap V3 is a risk amplifier
In the above discussion, we have always used the classic model of Uniswap V2 as the reference standard when evaluating market-making activities. However, we know that Uniswap has greatly improved the efficiency of capital use in the latest V3 version, and the shape of its end-of-period yield curve will inevitably be different from the previous V2 version. Let’s re-update the previous end-of-period income image and introduce strategy 5, which is to use the same funds to purchase the end-of-period return of the “LP Position Fund” provided by Uniswap V3.
It can be clearly seen from the above figure that, compared with the previous strategy 4 (Uniswap V2), strategy 5 (Uniswap V3) not only greatly improves the investor’s income level when the price is stable, but also greatly increases the price overrun at the end of the period. After the safety margin, the investor’s degree of loss. Therefore, Uniswap V3 is not only an amplifier of investor income, but also an amplifier of risk. Investors in the V3 version of “LP Position Fund”, while enjoying higher investment returns, must also bear more impermanent losses when the price falls out of the safe range at the end of the period.
High returns inevitably lead to high risks. This unchanging law in finance has not changed even in the world of blockchain.
Short volatility is the most dangerous investment strategy in the crypto industry
Through the above discussion, we have clearly understood the basic premise hypothesis for liquidity providers (LP) to make profits, that is: trading pairs that you participate in market making will not happen during your expected investment period. price fluncuation. If this premise is falsified during the investment period, the end of the market value of the investor will often be lower than the end of the market value of the initial asset portfolio without participating in market making.
This default assumption of low volatility is ubiquitous in the current cryptocurrency investment industry. For example, we can often see that the annualized rate of return of certain project mining activities exceeds 1000%. Behind these extreme rates of return, there are often implicit assumptions that the price of related tokens will never change.
Many investors, after participating in some so-called “high-yield” activities, often feel that their final returns have not reached the initial expectations, and even suffered losses. The root cause is often not that there is a problem with the calculation process of the project party’s rate of return, but that the “premise assumption” for low volatility is incorrect.
The current crypto industry is still an extremely emerging investment field, and the prices of various products are extremely volatile. Therefore, any assumption of low volatility may cause investors to pay a heavy price. I am not here to discuss the defects of the Uniswap V3 model. On the contrary, I think that the Uniswap V3 version is an extremely important innovation in the industry, because it gives investors the power to take the initiative to take higher risks and obtain correspondingly higher returns. Returning the final option of risk-taking to the market is the most important innovation in the underlying logic of Uniswap V3.
However, for ordinary users participating in V3 market-making activities, they must understand that this is just a re-balance between risk and return. Don’t simply see the rate of return of others, enter blindly without understanding the inherent risk logic, and ultimately bear the impermanent loss that you cannot bear.
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