In the early days of Uniswap V3's launch, many LPs who were the first to join the market making for V3 enjoyed a very high rate of return on fees. But the good times didn’t last long. The entire encryption market suffered a sharp price drop in late May. Many V3 LPs found that not only did their market-making positions become the one with the relatively lower price in the trading pair, but And the degree of loss of the entire position in market fluctuations has increased significantly compared to V2 market making.
So, what is the change in the risk borne by LPs of Uniswap V3 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 view "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 risk of changes in the ratio of different currencies and price changes. Therefore, relying solely on the rate of return as the only indicator for investment decision-making obviously has serious flaws.
So, how can we more comprehensively evaluate the pros and cons of providing liquidity? Here, we suggest that participants switch to a fresh perspective to think about the whole problem. That is, viewing the provision of liquidity as a portfolio management strategy employed by investors.
This strategy, on the one hand, does not need to rely on the subjective judgment of the fund manager for manual operations; on the other hand, it dynamically adjusts the investor's position ratio based on a fixed algorithm based on changes in market prices. This new portfolio management strategy, which not only absorbs the essence of passive management funds without manual intervention, but also combines active and active position adjustment mechanisms, we renamed it "Active Passive Asset Management Strategy".
From this perspective, the former LPs will no longer be regarded as liquidity providers of the trading platform, but as investors who want to maintain 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 of being an investor in this "active passive asset management" fund?
Impermanent Loss and Inventory Risk
Choosing a reasonable performance evaluation benchmark is the most critical premise for evaluating the risk-return situation of a certain investment portfolio. To evaluate the risk-return situation of a credit bond, we can choose the national bond interest rate without credit risk as the evaluation benchmark; to evaluate an actively managed stock investment fund, we can choose the comprehensive index of the stock market in the same period. Generally speaking, which benchmark to choose to evaluate investment performance mainly depends on the other optimal choices that investors have when they are not involved in this investment, which is what we often call "opportunity cost".
So to evaluate this "fund" named 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, holding ETH in full position can be used as his evaluation benchmark; for investors who are short on ETH, holding all U.S. dollars can be his evaluation benchmark; for the expected ETH price will not fluctuate significantly Investors who maintain the status quo and do not participate in market making can be used as his evaluation benchmark.
From this, we constructed the following four different investment strategies (all with an initial total amount of $1000):
1.100% holding ETH
2.100% hold USDC
3. 50% hold ETH, 50% hold USDC
4. 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 investment portfolio, and the horizontal axis shows 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 investment portfolios at different ETH end-of-period prices.
It can be seen that if the end-of-period price of ETH has not changed relative to the start-of-period price ($3,000), the end-of-period market capitalization of the four strategies will also remain the same ($1,000). However, if the price of ETH falls, strategy 2 (holding USD) is the best choice; if the price of ETH rises, strategy 1 (holding ETH) is the best choice.
It is very worth noting that if an investor chooses strategy 4 (green line), that is, buys a fund named "LP Position" with $1,000 to participate in market making, the end-of-period market value of the fund will be excluding the starting point of the price. Always below strategy 3 (yellow line). And this part of the difference is what we often call "impermanent loss". What the impermanent loss reflects is that this fund named "LP Position" actively adjusts its position management when the price changes, which is expected to bring additional losses to investors.
Let us return to the investor's perspective. Assuming that investor A expects the price of ETH to rise in the future, if he bought the "LP Position" fund at the beginning of the period, what risks will investor A take when the price of ETH actually rises?
Since investor A purchased the "LP Position" fund, he will bear the impermanent loss risk brought by the fund when the price rises, which is the difference between strategy 3 and strategy 4. At the same time, since its optimal strategy should be to hold ETH in full position, it will buy 50% USDC exchanged by the "LP Position" fund, and will not be able to enjoy the benefits brought by the subsequent rise of ETH. Therefore, this part of the position will be given to investor A Bringing "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 "LP Position" fund market making will be far greater than the risk of impermanent loss. From this we can draw the following conclusions:
1. For investors who expect the price of ETH to rise, buying the "LP Position" fund will make them bear a huge inventory risk. Therefore, its optimal strategy should be to stay away from market-making activities and look for other ETH-based investment tools (such as participating in Ethereum 2.0's PoS pledge activities).
2. For investors who expect the price of ETH to fall, they should also stay away from market-making activities, so as not to passively hold ETH and bear the inventory risk of its falling price. Its optimal strategy should be to look for stablecoin-based financial management or mining activities.
3. For investors who expect the price of ETH to remain stable, there is not much difference between holding ETH or USDC (because they expect the price fluctuation between the two to be small). Therefore, it would be a good choice to use two currencies to purchase some kind of "financial management product" to earn income.
But we just mentioned that buying this kind of fund called "LP Position" has a negative net return relative to not buying it (the market value at the end of strategy 4 is always smaller than strategy 3). So why should investors become LPs and make markets for trading platforms?
Handling fee is compensation for impermanence 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's take the impact of handling fees into consideration again, and see what changes the different strategies will bring to investors' end-of-period market value in real situations.
We found that when the handling fee is taken into consideration again, it makes sense to buy "LP Position" funds to participate in market making. Because of the fee income as compensation, within a certain price range, the end-of-term market value of strategy 4 (green line) is finally higher than that of strategy 3 (yellow line). Therefore, the logic for investors to buy "LP Position" funds to participate in market-making activities has also been clarified: in order to obtain positive returns within a certain end-of-period price range, investors have to bear the risk of losses after the end-of-period price fluctuation exceeds this range.
That is to say, the prerequisite for participating in market-making activities to obtain positive returns is that investors expect that the price of assets at the end of the period will not fluctuate significantly. Once the end-of-period 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 call the provision of liquidity to make the market "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 for evaluating market-making activities. But 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. Next, 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 "LP Position Fund" provided by the Uniswap V3 version.
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 current end-of-period price exceeding After the safe range, the extent of the investor's loss. Therefore, Uniswap V3 is not only an amplifier of investors' income, but also an amplifier of risks. Investors of the V3 version of "LP Position Fund" enjoy higher investment returns, but also must bear more impermanent losses when the end-of-period price falls out of the safe range.
High returns inevitably bring high risks. This eternal law in finance has not changed a bit even in the blockchain world.
Shorting volatility is the most dangerous investment strategy in the crypto industry
Through the above discussion, we have clearly understood the basic premise that the liquidity provider (LP) can make a profit, that is: the trading pairs that we participate in the market making will not have large fluctuations during the expected investment period. price fluncuation. If this premise is falsified during the investment period, the end-of-period market value of the investor will often be lower than the end-of-period 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 often see that the annualized rate of return of certain project mining activities exceeds 1000%. Behind these extreme rates of return, there is often an assumption that the price of the relevant token will never change.
After participating in some so-called "high-yield" activities, many investors often feel that their final income has not met their 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 encryption industry is still an extremely emerging investment field, and the price volatility of various products is extremely high. Therefore, any assumption of low volatility may cause investors to pay a heavy price. Here I do not want 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 actively choose to take higher risks and obtain correspondingly higher returns. Returning the final choice of risk taking to the market is the most important innovation of Uniswap V3 in terms of underlying logic.
However, for ordinary users who participate in V3 market-making activities, they must understand that this is just a re-balancing between risks and benefits. Don't simply see the rate of return of others, enter blindly without understanding its inherent risk logic, and ultimately bear impermanent losses that you cannot bear.
