Greater risk results in a greater return?- SheepDex came up with a new idea for DeFi
With concentrated liquidity, SheepDex can improve capital efficiency hundreds of times, which also increases the threshold for DeFi users. Today, many users still use DEXs that offer v2 or traditional AMM mechanisms, which means that there are still a large number of users who do not enjoy the higher capital efficiency that v3 brings.
As a liquidity provider (LP) or a portfolio manager, it’s very important to provide liquidity objectively. SheepDex allows LPs to earn trading fees and generate mining income. However, LPs will also be exposed to changes in the proportion and price of the two assets. Therefore, we can’t just make investment decisions relying on the rate of returns.
So how can we fully assess the pros and cons of liquidity provision? It is recommended that participants think about this in a new way, with liquidity provision as a portfolio management strategy for investors.
On the one hand, this strategy does not need to rely on the subjective judgment of the portfolio manager for manual operation; On the other hand, it can dynamically adjust the proportion of the positions according to a fixed algorithm based on changes in the market prices. This new portfolio management strategy incorporates the essence of passive fund management without human intervention, combining active and proactive positioning. We renamed it the active asset management strategy.
From this perspective, former LPs will no longer be viewed as liquidity providers, but as investors seeking to preserve and grow their own assets. The evaluation of whether it should become a standard LP will also change from just a market-making rate of return to the expected rate of return of the portfolio and the risks that may be taken in the investment process.
So what will be the risks for an investor in such active asset management?
Impermanent Loss & Inventory Risk
This could be called an “equity fund” of LP positions, so what metrics should investors take as the benchmark to evaluate the fund?
Let’s take ETH-USDC as an example. For investors who are bullish on ETH, ETH long positions can serve as a benchmark; For those who are bearish on ETH, USDC long positions can serve as a benchmark; For investors who expect ETH price will not fluctuate significantly, keeping the positions and not participating in the market making can serve as the evaluation benchmark.
As a result, we constructed the following four different strategies (each with a beginning market value, or BMV, of $1000) :
1.Holding 100% ETH
2.Holding 100% USDC
3.Holding 50% ETH and 50% USDC
4. Purchasing an LP Position Fund for market-making with 50%ETH and 50%USDC
As you can see, if the EVM of ETH does not change relative to the BMV ($3,000), EVMs of the four strategies will remain the same ($1,000). But if the price of ETH falls, strategy 2 (holding 100% USD) would be an optimal choice. If the price of ETH rises, strategy 1 (holding 100% ETH) is an optimal choice.
It is worth noting that if the investor chooses strategy 4 (the green line), which involves buying the LP Position fund with $1,000 for market-making, the fund’s EVM will always be lower than strategy 3 (the yellow line), except for the BMV. This difference is what we call impermanent loss. The impermanent loss reflects the additional losses that investors are exposed to when they adjust positions when prices change.
Let’s go back to the investor point of view, assuming that investor A expects ETH price to rise in the future, what risks will he take if he buys the LP Position fund at the early stage when ETH price rises?
Since investor A purchased the LP Position fund, he will be exposed to the risk of impermanent loss when the price rises, which is the difference between strategy 3 and strategy 4. At the same time, since its optimal strategy is to hold ETH in its entire position, it will not be benefited from the subsequent rise of ETH from the 50% USDC converted by the purchase of LP position. Therefore, this position would cause investor A a loss of inventory risk, which is the difference between strategy 1 and strategy 3.
Therefore, for investor A, the inventory risk associated with buying the LP Position market-making fund will outweigh the risk of impermanent loss. From this, we can draw the following conclusions:
- For investors who expect ETH prices to rise, buying LP Position will expose them to inventory risk. Therefore, the optimal strategy should set the price range above the spot position for selling high.
- For investors who expect ETH price to fall should set the price range below the current price to facilitate buying low.
3. There is little difference between owning ETH or USDC for investors who want the price of ETH to remain stable (because they think the price fluctuation between the two is negligible).
Therefore, using these two currencies to buy a certain type of asset management product to get income may be a good choice. The price range should be around the current price and more profits should be gained through aggressive trading.
Buying this LP Position fund has a negative net return relative to not buying it (the market cap of strategy 4 is always smaller than strategy 3). So why do investors still act as LPs for trading platforms for market-making?
Trading fees and yield farming can trade-off against impermanent loss
To simplify the model, we ignore the impact of trading fees and yield farming on the EVM. Now let’s review the impact of trading fees and yield farming and see how different strategies in the real world can change the EVM for investors.
It makes sense to buy an LP Position fund for market-making as trading fees and yield farming are reconsidered. Within a certain price range, the EVM of strategy 4 (green line) is higher than strategy 3 (yellow line) due to compensation for trading fees and yield farming. Therefore, the logic of investors buying LP Position funds for market making is clear: in order to obtain positive returns within a certain range of EVM, investors are willing to undertake the loss caused by EVM fluctuation exceeding the range.
In other words, participation in market-making activities can achieve positive returns.
With SheepDex’s V3 active asset management, each fund needs a manager or a group of managers responsible for determining the fund’s portfolio and investment strategies. With professional knowledge and expertise, the fund manager can adjust, maintain and innovate the portfolio and strategies according to the market changes to constantly realize value appreciation. Therefore, v3 can really allow investors to proactively initiate and create multiple value curves with higher returns than V2. Moreover, it would also be interesting to investigate the maximum benefits of implementing a strategy.
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