Michael Bodley


<p>MEV Capital, a DeFi-focused institutional investment manager, is rolling out a new impermanent loss hedging product designed to provide downside protection on Uniswap yields — and its exact structure is said to be the first of its kind.</p>



<p>MEV’s offering has been introduced to potential limited partners via separately managed accounts (SMAs), according to a source familiar with the matter and marketing materials obtained by Blockworks.&nbsp;</p>



<p>Its core strategy consists of exotic, short-dated crypto options that are designed to provide downside protection, while generating returns on DeFi yields via Uni v3. MEV has tapped Singapore-headquartered OrBit Markets, which specializes in sector derivatives and structured products, as a counterparty, the source said.&nbsp;</p>



<p>Impermanent loss in a DeFi context: risking the cost of running a Uniswap pool that slips below total fees generated in doing so. Scores of MEV competitors have launched their own impermanent launch strategies.&nbsp;</p>



<p>The firm’s thinking, according to the source, is that and to its knowledge, other traders have done so via perpetual swaps. These differ in that customers rely on perps on those to cover DeFi yield-farming downside by taking a short position.&nbsp;</p>



<p>“That’s not a complete hedge,” one source said. “It’s not a full cover.”</p>



<p>MEV has one additional and undisclosed counterparty, the source said, who categorized the service provider as an established commodities market maker with growing digital assets interest. The source was granted anonymity to discuss sensitive business dealings.&nbsp;</p>



<h2 class="wp-block-heading">How MEV hedges impermanent loss in DeFi</h2>



<p>The Lithuania-based MEV has $32 million of assets under management. Its trading is led by Chief Investment Officer Laurent Bourquin, a veteran of French bank Societe General’s investment banking division, where he worked on leveraged finance products, as well as additional asset classes.</p>



<p>Bourquin co-founded MEV in 2020 — which now has nine full-time staffers — with fellow general partner Gytis Trilikauskis, the asset manager’s chief operating officer. </p>



<p>Trilikauskis confirmed the formation of MEV’s latest strategy in a Blockworks’ interview on Friday. He declined to comment on his firm’s marketing materials or investor communications.</p>



<p>Here’s how it works: </p>



<ul>
<li>Limited partners buy in to the strategy via SMAs, and their positions are held on decentralized exchange (DEX) <a href="https://blockworks.co/tag/uniswap" target="_blank" rel="noreferrer noopener">Uniswap</a>.</li>



<li>MEV with LP assets acts as a market neutral liquidity provider for Uni crypto pools, such as WETH/USDC. The firm is on the lookout for pricing discrepancies that may trigger a higher payout on fee payouts for providing that liquidity.&nbsp;</li>



<li>Investor yield, meanwhile, is designed to be generated from capturing “organic trading volume” on the DEX, according to MEV’s investor documents.&nbsp;&nbsp;</li>



<li>The idea is to lock down initial returns from that yield, then deploying hedges on those assets via options designed to proffer downside protection against impermanent loss.&nbsp;</li>



<li>Options contracts are settled with Orbit and the under wraps commodities market maker, and capital is dispersed accordingly.</li>
</ul>



<p>The crypto options are settled over the counter, a result of digital asset derivatives liquidity remaining hard to come by at any sort of institutional scale. They’re held open for a week or two.</p>



<p>It’s incumbent on MEV to carefully manage its risk on its open options, given rapid market swings in the cost of carrying derivatives that act as a hedge.</p>



<p>Not to mention the volatility of their underlying cryptoassets.&nbsp;</p>



<p>Traditional financiers can and do structure their own options via OTC methods. But they have at their disposal far more possibilities to open and settle options without them. Not to mention far more derivative market makers to choose from — and their associated cost of carry.&nbsp;&nbsp;&nbsp;</p>



<p>Options market makers have developed a great deal in crypto since they hit the market, but industry participants say there’s still a long way to go in terms of their ability to maintain the prerequisite, voluminous balance sheet needed to ensure liquidity by keeping an abundance of options open on their books.</p>



<p>MEV has previously launched crypto structured products, as well as additional strategies that rely on sector products that are far from established and normative within the industry.</p>



<p>From buy siders to trading desks to limited partner pockets, Wall Street takes for granted the ease of slapping down a trade on a complex, synthetic exposure to commodities and structured products, Trilikauskis told Blockworks.&nbsp;</p>



<p>Trilikauskis and his counterpart general partner, Bourquin, have been designing DeFi plays since the summer of 2020, when MEV first started allocating capital. The firm’s flagship fund focuses on stablecoin yields, and the operation in May of last year introduced an Ethereum strategy.</p>



<p>There have since been sector structured product plays rolled out. MEV since its inception has really been in the business of “yield generating strategies on DeFi exclusively,” Trilikauskis said, “not dealing with centralized exchanges, not dealing with centralized lenders.”</p>



<p>As to the “why now” behind the Uniswap product, a number of factors are, in MEV’s estimation, in play, according to Trilikauskis: increasingly inflationary DEX governance tokens that power Uniswap and its competitors; decentralized market making volumes evaporating, dragging the governance tokens that power DEXes down with the liquidity ship.</p>



<p>That said, DEX market making payouts are still hovering “on the very low end of its historical range,” according to the marketing materials, even if volumes are still chasing historic highs. </p>



<p>What that boils down to is that MEV will have to raise — then deploy — a good chunk of limited partner capital to profit off of fees alone, even with vDEX volumes where they are.</p>



<p>High.</p>



<h2 class="wp-block-heading">Uniswap pool opportunity set</h2>



<p>In the WETH/USDC example, MEV has told investors it expects it to generate $20 to $60 billion in volume early this year. The Uniswap pool’s payout is a puny 0.05%. Generating yield from those fees relies heavily on traders pushing cryptoassets into decentralized pools.</p>



<p>The firm’s view is that crypto options markets have yet to properly price the potential fees that can be earned from DEXes’ resulting in arbitrage plays between on-chain assets and options exercised on them.&nbsp;</p>



<p>Over the long haul, MEX is telling current and potential investors that the dislocation will lessen eventually. The firm in its marketing materials said “we see opportunity” in the “short-to-medium-term” in terms of cashing in on dislocations as off-chain options “become more competitively priced.”</p>



<p>SMAs — as opposed to liquid crypto hedge funds that lock up investor capital — generally function with instantaneous liquidity measures. The setup was pioneered in traditional finance, though blockchains may add additional visibility into a strategy’s book in terms of tracking trades.</p>



<p>The setup has been favored by both crypto native limited and general partners, as well as their Wall Street counterparts, and the sentiment has been only heightened by volatility that’s rocked just about every corner of crypto since the fourth quarter.&nbsp;</p>



<p>MEV is betting on those perceived benefits and others in marketing its hedging strategy settled by OrBit Markets.&nbsp;</p>



<p>“What we saw was unique: to be a mercenary in DeFi now,” Trilikauskis said. “Until now, you needed to fund from opportunities [on the market]. Usually, you stay in a liquid position or a [yield] farming position for two to three weeks under the APR, which is slowly grinding down to something that is not attractive.”</p>



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DeFi Startup Wants To Help Traders Hedge Uniswap Impermanent Loss

John Gilbert


<p>Investors often claim that you can’t see the full damage of impermanent loss until funds are withdrawn. According to the experts at Amberdata though, this isn’t the case. All data is open and measurable. Anyone can provide an estimate. The real challenge is finding a precise calculation and in analyzing the risk of impermanent loss versus the reward of transaction fees.&nbsp;</p>



<p>The complexity of data sources makes this analysis difficult to account for all investment strategies. But a review of the basics can provide the tools necessary for such a report.&nbsp;</p>



<p>We sat down with <a href="https://www.amberdata.io/?utm_campaign=2022-Q3-Blockworks-Investor-Guide&amp;utm_source=Report" target="_blank" rel="noreferrer noopener">Amberdata</a>, a leader in cryptoeconomic data, to better understand impermanent loss (IL) and how to navigate it. This guide will offer context to IL by explaining the technology behind automated market maker (AMM) liquidity pools. It will explain why it happens and why it is difficult to assess. And it will detail the data resources needed to detect clues before loss occurs.&nbsp;&nbsp;&nbsp;</p>



<h2 class="wp-block-heading">When does impermanent loss happen?</h2>



<p>Impermanent loss happens when the price of a token changes relative to its pair, between the time you deposit it in a liquidity pool and when you withdraw it.&nbsp;</p>



<p>Think of it as primarily an unrealized opportunity cost. It’s not a real loss, because the loss is measured against the value your investment would have been if the tokens were held outside of the liquidity pool. So if you are measuring your investment in cash, impermanent loss may not cause you to lose money. And it’s unrealized because token pairs can return to the same ratio before liquidity is withdrawn.&nbsp;</p>



<h2 class="wp-block-heading">Where does it occur?</h2>



<p>Impermanent loss can occur in any decentralized exchange (DEX) that uses liquidity providers to fund pools segregated by trading pairs. But before we explain the mathematical phenomenon of the loss, we need to explain the purpose behind this new type of exchange and how it works.&nbsp;&nbsp;&nbsp;&nbsp;</p>



<h2 class="wp-block-heading">Decentralized Exchanges</h2>



<h3 class="wp-block-heading">The purpose</h3>



<p>DEXs were created for people to swap different tokens without a trusted third party. Unlike a centralized exchange (CEX), assets remain in your wallet and the exchange never has custody of them. They use two blockchain-based innovations to maintain decentralization: automated market maker algorithms and liquidity pools.</p>



<h2 class="wp-block-heading">Automated Market Maker Algorithms&nbsp;</h2>



<p>An automated market maker algorithm is what sets the exchange rates for specific asset pairs within a DEX.&nbsp;&nbsp;</p>



<p>The traditional CEXs facilitate trades through an order book. Exchange rates are set when buyers create demand and sellers offer supply. The order book matches the price a buyer is willing to pay with the price a seller is willing to accept.</p>



<p>In contrast to setting prices to match buy and sell orders, AMM algorithms are programmed to automatically adjust exchange rates to keep the supply of paired tokens balanced within a pool.&nbsp;&nbsp;</p>



<h2 class="wp-block-heading">Liquidity Pools</h2>



<p>Liquidity pools are smart contract enforced deposits of two tokens needed to enable swaps on a DEX. These pairs are usually set at a 50/50 ratio (but there are also uneven liquidity pools).</p>



<h3 class="wp-block-heading">How they work</h3>



<p>Imagine that you are a brand new exchange looking to open a single pool for BTC and ETH. Before anyone is able to swap BTC for ETH or vice versa, you need to attract liquidity providers to the pool.&nbsp;</p>



<h4 class="wp-block-heading"><strong>The liquidity provider&nbsp;</strong></h4>



<p>Exchanges do this by first charging a fee for every swap and then sharing those fees as rewards with all liquidity providers in the pool. For example, if you provide 1% of the liquidity in a pool, you’ll receive 1% of the fees for that pool. Understanding the fee structure is critical to assessing the risk vs reward of adding liquidity. Because ultimately, the rewards from fees could more than offset the risk of impermanent loss.&nbsp;</p>



<p>In the ETH/BTC pool, a liquidity provider would need to include both tokens in their deposit. Most exchanges require a 1:1 ratio. So if a liquidity provider deposited 2 BTC and 1 BTC = 5 ETH, then you would need to match your BTC with 10 ETH. Once funds are deposited, you are given LP tokens as a representation of your percentage of the combined value of both tokens in the pool. LP tokens earn rewards from transaction fees and can be used to farm yield outside of the protocol.&nbsp;</p>



<h4 class="wp-block-heading"><strong>The trader</strong></h4>



<p>Now that you have attracted enough liquidity providers, traders can start swapping tokens. But unlike CEXs, traders can’t toggle between their preferred token or currency in a single pool. Instead, they are required to swap one token for the other. So everytime BTC is withdrawn, the equivalent in exchange rate value is added in ETH — and vice versa.&nbsp;</p>



<h4 class="wp-block-heading"><strong>How AMMs price tokens and balance liquidity pool</strong>s</h4>



<p>At a pool&#8217;s onset, AMMs use market rates to set prices and an equal balance in value between the supply of both tokens. So if 1 BTC = 5 ETH, total supply in the pool will reflect that ratio. As users swap tokens, the AMM uses a mathematic formula to adjust prices and balance the liquidity pool.&nbsp;</p>



<p>For example, say that there was initially 100 BTC and 500 ETH in the pool. The current price of BTC would therefore be 5 ETH. If you were to take 1 BTC for 5 ETH, the total supply would be 99 BTC and 505 ETH. This would change the price of BTC from 5 ETH to about 5.1 ETH.&nbsp;</p>



<p>But say market-wide, the price of BTC is still 5 ETH. Arbitrage traders would then take that opportunity to buy BTC at a discount and sell it for ETH in the liquidity pool. This arbitrage would continue until the price falls back to market rates.&nbsp;</p>



<h2 class="wp-block-heading">Examples of impermanent loss</h2>



<p>The ultimate cause of impermanent loss is unequal price changes. Though, it is important to remember that your return is calculated after collecting fees. So even if unequal price fluctuations cause impermanent loss, you may still be able to make a profit if rewards from transaction fees cover the difference.&nbsp;</p>



<p>For example, let’s say an ETH/BTC pool is programmed to keep the value of both baskets set at a 1:1 ratio. Meaning, the value of all BTC should be the same as all ETH. At the time of your deposit, 1 BTC equals 10 ETH across most other exchanges, so you deposit 4 BTC and 40 ETH.&nbsp;</p>



<p>At the time of depositing the tokens, the size of the pool was 20 BTC and 200 ETH, so your total share of liquidity is 20%.&nbsp;</p>



<p>A month later, <strong>ETH doubled in value while BTC’s price stayed the same.</strong> But the value of both token baskets in the pool don’t yet reflect the ETH market-wide price of .2 BTC. So arbitrage traders rush in to buy ETH at the discount until the pool ratio and token prices match the market rate.&nbsp;</p>



<p>So once the pool supply reaches 20 BTC and 100 ETH, your 20% deposit will be worth 4 BTC and 20 ETH. That is a 20 ETH price difference from the initial 40 ETH deposit, resulting in an impermanent loss of 20 ETH. But it just so happened that transaction fees were extraordinarily high, providing an additional 10 ETH to your share of the pool. In this case, the loss on your return would only be 10 ETH at market value. It is impermanent because the supply of tokens in the pool can return to a 1 BTC to 10 ETH ratio in the future. The loss becomes permanent once funds are withdrawn from the pool. But if a liquidity provider gains enough exposure, rewards from transaction fees can potentially make up for the impermanent loss.&nbsp;</p>



<h2 class="wp-block-heading">Is impermanent loss actually difficult to spot?</h2>



<p>The reason many find it difficult to spot impermanent loss isn’t because it is an inherent mystery &#8211; it is a calculable math problem. The team at Amberdata explained that due to its complexity, most resources only provide estimates.&nbsp;</p>



<p>Say that you use your LP tokens in a yield farming endeavor that generates rewards on another protocol. Estimates on the exchange can’t account for those rewards. So even if it is showing impermanent loss, it could be that your yield farming endeavor makes back the loss.&nbsp;&nbsp;</p>



<p>A full assessment requires multiple data points, but if you have a clear view of what&#8217;s needed, that calculation can be precise and provide actionable investing data.</p>



<p>Plus, IL is different for everyone because portfolios have a different mix of tokens pairs. People also don’t deposit and withdraw at the same times or prices.</p>



<p>To calculate PnL for a liquidity position, you need data on:</p>



<ul><li>Each token’s price at deposit</li><li>The amount of each token deposited</li><li>Date of deposit</li><li>Rate of reward for the liquidity pool</li><li>Estimated price of each token at withdrawal</li><li>Date of withdrawal</li><li>LP token yield farming strategies&nbsp;</li></ul>



<p>Because there are so many variables in calculating the difference between projected gains from holding tokens versus LP fees, many struggle to make a useful conclusion about whether to enter or exit a liquidity pool.</p>



<p>As an added complication, the risk and reward is different for every token pair depending on each one&#8217;s volatility. The more diverse the portfolio, the more difficult this becomes.</p>



<h2 class="wp-block-heading">How to calculate impermanent loss</h2>



<p>There are detailed mathematical explanations for how to calculate IL, but in brief, a formula can be used. IL increases the more an asset’s price changes relative to its pair. This is plotted on a graph.</p>



<p>In this very simplified example, you can see that IL happens whether prices go up or down. But the loss is much greater as a token&#8217;s price goes down. This causes many liquidity providers to look for token pairs that are likely to appreciate at a similar rate over time.</p>


<div class="wp-block-image">
<figure class="aligncenter size-full"><img loading="lazy" decoding="async" width="926" height="514" src="https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png" alt="" class="wp-image-25712" srcset="https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=926 926w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=300 300w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=768 768w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=428 428w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=470 470w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=389 389w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=80 80w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=50 50w" sizes="(max-width: 926px) 100vw, 926px" /></figure></div>


<h2 class="wp-block-heading"><a href="https://www.amberdata.io/?utm_campaign=2022-Q3-Blockworks-Investor-Guide&amp;utm_source=Report"></a><strong>Can you avoid impermanent loss?</strong></h2>



<p>Since impermanent loss is triggered by unequal prices changes, the best way to avoid it is by avoiding volatile token pairs. But Amberdata stresses that there are always a wide array of investment choices in a cost-benefit analysis. For example, simply avoiding IL may not make sense when you measure a pool’s IL costs vs transaction fee rewards. The most informed decision evaluates the potential return in relation to other pools and opportunities. This comprehensive approach helps the liquidity provider find alpha.</p>



<p>In our conversation, Amberdata said that they offer their clients comprehensive insights across decentralized finance, and can quantify historical performance in context to other liquidity pools and investment strategies. They provide the data needed for a full risk/reward assessment that ultimately informs liquidity providers in their search for alpha.&nbsp;</p>



<p>One of the most useful tools for providing liquidity is <a href="https://www.amberdata.io/?utm_campaign=2022-Q3-Blockworks-Investor-Guide&amp;utm_source=Report">Amberdata’s impermanent loss endpoint</a>. With it, liquidity providers can get the exact data needed to evaluate IL risk for token pairs in specific liquidity pools on different DEXs.&nbsp;</p>



<h3 class="wp-block-heading">Why comprehensive data is important</h3>



<p>Amberdata said that their endpoint tools don’t take shortcuts when it comes to calculating impermanent loss. Their application collects liquidity pool data from across exchanges and tracks activity to get accurate, customized calculations.&nbsp;</p>



<p>For example, many IL calculations do not account for the mints and burns that a liquidity provider may make in a single day. Minting refers to the LP tokens that are created when funds are deposited. Those tokens are then burned when funds are withdrawn. Liquidity providers will often try to time minting and burning to avoid volatile price swings in a pool. If their IL estimate is only a 24 hour snapshot of what impermanent loss would be from the start to the close of the day, then they will not be able to measure the impact of their liquidity positions. Amberdata takes those intraday mints and burns into consideration when calculating IL.&nbsp;</p>



<p>While the precision of an IL calculation is critical, it doesn’t provide the full story. Even if a liquidity provider is able to avoid IL through savvy burning and minting practices, it doesn’t mean that they maximized return. Effective back-testing of liquidity provider strategies requires comprehensive data points that detail the potential transaction fee rewards when an LP is in and out of a position. Amberdata said that they built their services so that liquidity providers could use this comprehensive approach to put their best strategies forward.</p>



<p><em>This post is sponsored by <a href="https://www.amberdata.io/?utm_campaign=2022-Q3-Blockworks-Investor-Guide&amp;utm_source=Report" target="_blank" rel="noreferrer noopener">Amberdata</a>.</em></p>



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