2x Your LP Value: Report on Automated Liquidity Management (Part I)
1. Summary
Y2K could have earned 162 ETH ($260K) over the last nine months by optimizing their protocol owned liquidity (“POL”).
This report presents the findings of the backtesting and research Sector Finance conducted on deploying automated liquidity management (“ALM”) strategies on Uniswap V3 using the Y2K Token as a case study.
For DAOs and platforms with protocol owned liquidity, we found that deploying ALM strategies on concentrated liquidity DEXes like Uniswap V3 led to significant improvements in LP value, capital efficiency, and token price levels.
Sector’s ALM strategy is optimized to increase the value of the liquidity pool (LP) and, as a result POL, over time. POL level is the most quantifiable measure of liquidity health and is a key resource in ensuring protocol stability and effectiveness in navigating different market scenarios. Optimizing for higher LP levels also resulted in longer-term capital efficiency improvements.
Sector Finance evaluated our market making ALM strategy against the 80:20 Y2K:ETH Balancer pool that Y2K currently utilizes for their POL. Here are some key findings on the benefits of Sector’s tested ALM strategy:
- LP Value: 1.9x higher LP value at period end with an average LP increase of 1.2x across the January to September 2023 backtest period.
- Capital Efficiency: 3.3x greater capital efficiency at period end with max capital efficiency reaching 3.9x and an average 1.9x improvement in the backtest period.
- Price Levels: ALM strategy leads to a 14% increase to price levels at period end, with an average price improvement of 9% across the backtest period.
- Deploying a portion of Y2K’s ARB Tokens received from the Arbitrum Foundation led to further improvements on capital efficiency and price levels.
While we use the Y2K token as a case study, our ALM strategy was built to optimize LP in different market scenarios. In the next part of our deep dive, we examine the ALM strategy performance under various market scenarios and randomly generated price paths. Following our research, Sector Finance plans to deploy ALM strategies on concentrated liquidity to further our goal of improving DeFi and crypto infrastructure.
2. Background
We selected the Y2K Token for our backtests because in the first 9 months of 2023 it experienced three different phases of price movements that are common for crypto protocols.
- Price spike: Jan to mid Feb
- Price stability: mid Feb to Mid march
- Price reversion: mid March to September
Definitions:
Y2K Finance: Y2K Finance is a suite of structured products designed for exotic peg derivatives, that will allow market participants the ability to robustly hedge or speculate on the risk of a particular pegged asset (or basket of pegged assets), deviating from their ‘fair implied market value’.
Balancer Pool: Balancer is a decentralized automated market maker (“AMM”) protocol that offers flexible pools options and weights compared to traditional AMMs.
Uni v3: The defining idea of Uniswap v3 is concentrated liquidity: liquidity that is allocated within a custom price range. With v3, liquidity providers may concentrate their capital to smaller price intervals than (0, ∞). As a result, traders are offered deeper liquidity around the price interval, and LPs earn more trading fees with their capital.
Automated Liquidity Management Strategies: While concentrated liquidity improved capital efficiency, new challenges arose around actively managing the position to counter market volatility and anticipate price trends. Sector’s ALM strategies automate this difficult management process. In our backtesting, we prioritized LP value, capital efficiency, and pricing support.
3. Methodology
The backtest parameters and conditions were optimized as such:
- The ALM strategies were simulated using historical swap data from the Balancer pool (80:20 Y2K:ETH) where Y2K deploys its POL
- We then compared the behavior of the ALM strategy against that of the Balancer pool
- The ALM strategy was built to optimize LP in different market scenarios and also tested using randomly generated price paths
- The test deploys approximately 88 ETH and four times as much Y2K, based on the original Y2K liquidity size
- Fees were kept consistent at 0.3%, the same as the Balancer pool.
- The time period is January to Sept 2023
- We also simulate additional Arbitrum liquidity injection to match 50% of Y2K’s allocated ARB tokens.
Our ALM Strategy revolves around the automated adjustment of liquidity parameters within predefined market-making ranges. The strategy is tuned to adjust parameters in both upward and downward market movements, ensuring the LP’s position is consistently optimized and the ranges stay profitable while rebalancing. The ALM strategy utilizes market volatility to the advantage of the LP, aiming to improve LP values, capital efficiency, and pricing levels all the while keeping trading fees low at 0.3%.
The strength of the ALM vault is most apparent when market volatility converges around a similar value such as during the Reversion Phase seen in Y2K’s token pricing. We also note that the strategy performs as well or better in other market scenarios, as we demonstrate through our backtests and research.
For backtesting results provided in this report, the Sector Team worked with Robo Labs and utilized their index and data management platform, Arkiver, along with other publicly available tools. Arkiver is a platform built by Robo Labs designed to make indexing, managing data pipelines & integrating blockchain data with Web3 applications as simple as possible. Sector Finance used and contributed to their backtesting framework: https://github.com/RoboVault/web3-backtest.
4. Y2K Token: Case Study
We compare our 80:20 Y2K:ETH ALM strategy against the Balancer pool and examine a variety of metrics including the impact of selling 10ETH worth of Y2K tokens, LP value, and Y2K token price across the January to September backtest period.
Liquidity Pool Value
Sector’s ALM strategy leads to an average 20% increase in LP with values reaching up to a 2.3x increase in the Reversion Phase. The ALM strategy is able to build LP value over time and in this case, grow ETH reserves so that it totals 50% of the LP pool. This is 5x the value of ETH in the Balancer pool!
Given the 80%:20% Y2K: ETH split, the ALM strategy utilized the additional Y2K tokens more effectively than Balancer. More Y2K tokens were sold as the price went up, allowing ETH reserves to be built to support the price during the Reversion Phase. This automated market making on the LP position takes away a portion of the profits from arbitrageurs for the benefit of the POL without increasing user trading fees. The lower LP levels compared to balancer during the Price Spike period was a function of building ETH reserves and bringing the pool closer to a 50%:50% Y2K:ETH balance.
Capital Efficiency
We examine capital efficiency in the context of sell pressure and the impact on token value. In comparing our market making ALM strategy against the Balancer pool, we measure the price impact of selling 10 ETH worth of Y2K Tokens.
In just 9 months Sector’s ALM strategy was 3.2x more capital efficient than the Balancer pool as a result of increased LP value. On average the ALM strategy was 1.9x more capital efficient.
Price Levels
The ALM strategy remains in-line with the Balancer pool during the Price Spike and Price Stability phase, however the Y2K token price sees significant improvements during the Reversion Phase. During the January to September backtest period the average price improvement is 9% higher reaching a max increase of 54% with the increase at period end being a 14% increase.
Arbitrum Liquidity Injection
Y2K Finance received approx. $1.5M worth of ARB tokens via airdrop from the Arbitrum Foundation. We test the improvements of adding 50% of the Arbitrum liquidity into the LP pool and note that capital efficiency improved to 4.4x at period end compared to 3.3x without the liquidity injection. From a pricing standpoint, the improvement was a 40% increase at period end compared to 14% without the additional ARB liquidity.
5. Demystifying Capital Efficiency
Capital Efficiency in DEX LP
In this section, we delve into the concept of capital efficiency, aiming to clarify common misconceptions and highlight why our ALM strategy focuses on maximizing LP values over capital efficiency.
Capital efficiency in the context of DEX LP is typically defined by the amount of liquidity provided within a specific price range around the current market price and the tightness of this range. However, it’s important to note that capital efficiency can be customized by increasing the liquidity amount or narrowing the range, making it a somewhat flexible but not an ideal metric to concentrate on.
Capital efficiency does come with trade-offs. The more liquidity you allocate to one price range, the less you have available for other price ranges when market prices shift. Additionally, when you continuously adjust ranges for high capital efficiency, you may inadvertently decrease the overall LP value.
Our Approach to Capital Efficiency
While we do consider capital efficiency around the current price range, especially to attract aggregator orders, our primary long-term optimization goal is the total LP value. Naturally, this approach leads to an improvement in capital efficiency over time.
We therefore evaluate capital efficiency based on its impact on mitigating sell pressure and its subsequent influence on token value. When comparing our market-making Automated Liquidity Management strategy with the Balancer pool, we focus on the price impact of selling 10 ETH worth of Y2K Tokens. Our analysis demonstrates that our ALM is up to 4.0x more capital efficient than the Balancer pool.
Our Strategy
The Sector ALM strategy emphasizes optimizing LP values while ensuring competitive capital efficiency within the current price range. Over time, this approach naturally enhances capital efficiency compared to traditional alternatives like the Balancer pool. We also offer customizable strategies tailored to optimizing capital efficiency within specific price ranges, providing flexibility to adapt to different liquidity requirements. This commitment to liquidity provisioning, combined with ongoing refinement, ensures protocols can effectively deploy and utilize their POL.
Ultimately the Sector ALM strategy’s focus on maximizing LP value offers numerous advantages for decentralized protocols. LP value provides a quantifiable measure of liquidity health, making it easier to assess the protocol token’s robustness. Higher POL levels allow protocols to respond more effectively to market dynamics and ensure a higher degree of stability.
6. Risks
While our backtesting and research have shown significant improvements in capital efficiency and price stability through our ALM strategy on concentrated liquidity, there are certain risks that need to be considered:
Market Volatility: Despite the ALM strategy’s efforts to counter market volatility, unforeseen and extreme market fluctuations could still impact the token price and liquidity, leading to potential impermanent loss for liquidity providers.
Regulatory Risk: The decentralized finance space is subject to evolving regulatory landscapes in various jurisdictions. Changes in regulations may affect the viability and implementation of ALM strategies.
Smart Contract Vulnerabilities: As with any smart contract-based protocol, there is always a risk of potential bugs, exploits, or vulnerabilities that could expose the protocol to security breaches and financial losses.
Automation Risk: The reliance on automated processes and keepers presents the risk of failure due to high gas fees, network congestion, or other technical issues.
7. Conclusion
Through this backtesting and research report, Sector Finance has demonstrated the significant benefits of deploying ALM strategies on concentrated liquidity DEXes like Uniswap V3. Our ALM strategy, when compared to traditional liquidity provision approaches such as the Balancer pool, has shown an average improvement of 1.9x in capital efficiency, reaching up to 3.9x in certain scenarios.
The ability to achieve higher LP values, enhance capital efficiency, and improve price stability provides a compelling case for DAOs and platforms with protocol-owned liquidity to consider implementing ALM strategies. Furthermore, the additional integration of Arbitrum liquidity has demonstrated even greater capital efficiency, resulting in a 4.4x improvement currently.
While we recognize the potential risks outlined in the previous section, we believe that with careful risk management and continuous refinement of our ALM strategy, these risks can be mitigated.
Based on the findings of this research, Sector Finance is committed to deploying ALM strategies on concentrated liquidity to support our mission of improving DeFi and crypto infrastructure. By providing enhanced liquidity provision services and stable token prices, we aim to contribute to the overall growth and sustainability of the decentralized finance ecosystem.
