How to Hedge Liquidity Pool Positions

DeFi Jun 1, 2022

Key Takeaways

  • Chasing high APR liquidity pools is a risky DeFi strategy and can result in significant financial loss.
  • Liquidity providers can hedge their liquidity pool positions by utilizing futures or lending and borrowing platforms.

Overview

Anyone who is somewhat familiar with the decentralized finance ecosystem is accustomed to the often absurdly high yield estimates offered across a variety of smart contract ecosystems and decentralized exchanges. Some platforms and newly released tokens have such high initial volume that users can see pool APRs fly well beyond even 500%. These yields are comprised of swap fees and sometimes also platform token rewards, an extra incentive for users to come and provide liquidity for newly listed pairs.

Although enticing, these yields do come with risk, and often times the exposure to the token pair’s price action can cause the liquidity provider (LP) to suffer a loss.

However, if LPs deploy a properly hedged strategy, they can participate in highly lucrative liquidity pools and, at the same time, minimize their downside risk. Indifference to the price action of underlying assets is referred to as a delta-neutral strategy, and it minimizes the risk of loss due to price drops and divergent loss in liquidity pools. These are risks that would usually need to be accounted for when providing liquidity to liquidity pools, and we will discuss the process of deploying a strategy that minimizes such risk.

The Risks of Liquidity Provision

The financial architecture of the traditional automated market maker (AMM) exposes liquidity providers to inherent risks that could lead to financial loss. Without diving too deep into the intricacies of the liquidity pool, liquidity providers are at risk because they are always accumulating more of the “losing token.” To find out more about the risks and benefits of being a liquidity provider, check out this article.

If Alice is providing liquidity to a pool of Token A and Token B, and the price of Token B appreciates while Token A remains stagnant, her holdings of Token A have most definitely decreased while her holdings of Token B have increased. Similarly, if the value of Token B drops while the value of Token A remains the same, the liquidity provider will end up accumulating more of the depreciating asset.

The magnitude of this difference in holdings is dependent on the amount of liquidity within the pool, the pool distribution, and the percent divergence between the two token prices. However, any divergence will mean that the LP would have been better off holding the two tokens in their wallet rather than providing liquidity. A liquidity provider's loss due to the divergence of token price is known as impermanent loss, and it can be visualized for different pool percent compositions using the graph below.

impermanent loss when hedging liquidity pool positions
Image via Coinmonks 

Decentralized exchanges reimburse liquidity providers by charging swap fees, and some DEXs even reward LPs with “farming rewards.” Yet despite both incentives, providing liquidity for a token that loses a tremendous amount of value will more often than not lead to financial loss for liquidity providers.

Hedging Your Liquidity Pool Position

In order to hedge against the downward price movement of tokens being provided within a liquidity pool, LPs must short a portion of the non-stable/base tokens provided. Permissionless short positions can be achieved by utilizing decentralized lending or derivative protocols like SynFutures. The value of a non-hedged or “delta positive” liquidity pool position in terms of the stable or base token can be seen below.

Value of an LP position when hedging liqudity pool positions
Image via Guillaume Lambert on Medium

To hedge your position, you must borrow a portion of the liquidity that you are providing. In doing so, you are able to rake trading fees during high volume and will benefit the most when there is minimal impermanent loss. This happens since you will retain the initial amount borrowed plus trading fees mad, and will only have to pay off the interest charged for borrowing. However in the case where the prices due diverge significantly, LPs will suffer a small loss since they will have to reacquire the assets lost due to impermanent loss.

In the case where half of the liquidity provided is borrowed, the profit/loss of the graph will not resemble a square root graph of the price, but rather is flattened out as shown below:

Value of a delta-neutral LP position
Image via Guillaume Lambert on Medium

This hedged liquidity pool position’s value accrues mainly through fee accumulation and will sustain its value through approximately +- 40% in asset price fluctuation. Liquidity providers can fine tune this strategy to more accurately reflect their outlook on the underlying asset’s price action, and short more or less of the tokens accordingly.

Using Crypto Derivatives to Hedge Liquidity Provision

Another option liquidity providers have to hedge their liquidity pool positions is by trading crypto derivatives to obtain short exposure to the pooled assets.

In contrast to using a lending protocol, utilizing derivatives can make the process easier and maybe even more capital efficient. A liquidity provider can short the riskier asset in the token pair that they are supplying liquidity to, and therefore cover the downside risk associated with having price exposure to the underlying digital asset. Through this, the fees and rewards accumulated can be cashed without having to worry about a downward price swing. However gains will also be capped since appreciation of the asset will also result in a loss.

The main issue with this strategy is that it is often difficult to find a platform which allows you to trade derivatives on an obscure or newly released token. For this reason, obtaining short exposure to that asset will require you to search across a variety of different protocols, with your best chance being a decentralized derivatives platform. There are many centralized and decentralized derivative platforms to choose from, and some may be easier to use than others. Major decentralized derivative exchange platforms include DYDX, Synthetix, and SynFutures. These platforms allow users to permissionlessly trade derivatives for a variety of different cryptocurrencies, and therefore make shorting different tokens a seamless process.

Want to learn more about trading fungible assets or listing your own contracts? Try out our Crypto Futures feature now in beta.

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