Uniswap V3 Delta Neutral Strategy — Part 2
Welcome back, Neutrons!
We’re thrilled about the success our USDC LP Market Neutral vault has achieved. However, we believe there’s always room for growth and innovation. With a steadfast commitment to enhancing your investment experience, we’ve been rigorously refining our strategies. Our aim? To elevate your yields while meticulously managing risk.
In Q3 2023, our team initiated a comprehensive strategic overhaul. We re-evaluated our vaults and brainstormed innovative approaches, The outcome? A decisive pivot: transitioning our vault to a 100% Uniswap V3 Delta Neutral strategy. This move leverages Uniswap V3’s advanced features to amplify Neutra investment potential.
In this Part 2 article , we will explore our enhanced strategies and backtesting results, aiming to redefine market neutrality in the DeFi space.
TL;DR
- Transitioned nUSDC vault from Camelot DEX to a full-fledged Uniswap V3 Delta Neutral strategy, leveraging Uniswap’s Concentrated Liquidity to enhance investment approach.
- This strategy finely balances shorting ETH through Aave with long positions in the ETH/USDC Uniswap V3 pool, targeting fee maximization while reducing market exposure.
- Features an auto rebalance algorithm with auto-compounding, optimizing portfolio balance and risk management in response to market dynamics.
- Extensive backtesting, involving approximately 260,000 data points, guiding us to refine and identify the optimal settings for our strategy.
Back to Basics: What is Delta Neutral?
Delta Neutral is a strategy designed to counterbalance market volatility. It involves simultaneously opening short and long positions to maintain a position neutral to market movements. The goal is to earn fees or interest, akin to providing liquidity, while minimizing exposure to market fluctuations. This is where Uniswap V3’s ‘Concentrated Liquidity’ feature becomes pivotal, as it allows for more capital efficient compared to traditional AMM (x * y = k).
Before diving deeper, it’s important to understand how Uniswap V3 works and its associated risks. For a detailed explanation, we encourage you to refer to Part 1 of our series. Read Part 1
Uniswap V3, as outlined in Part 1, poses a higher risk of impermanent loss than V2 — potentially up to 27 times greater, based on our calculations. Neutra focused on minimizing these risks while capitalizing on Uniswap V3’s potential for fees earning.
As we delve into the intricacies of our strategy, it’s important to understand that achieving delta neutrality in the dynamic world of DeFi is both an art and math. Our approach combines the sophisticated mechanisms of Aave’s protocol with the advanced liquidity provisions of Uniswap V3. This blend of techniques is the core of our strategy, aiming to balance and offset market risks while optimizing returns.
Hedging with Aave
In Delta Neutral pursuit, Neutra leverages Aave’s lending protocol to short ETH by borrowing it. This borrowed ETH is then used to establish a long position by providing on Uniswap V3 liquidity pool. This approach exemplifies the essence of a delta neutral strategy — offsetting our exposure to ETH’s price movements.
By shorting ETH via Aave (i.e., borrowing ETH), we effectively hedge against potential declines in ETH’s value. Simultaneously, by placing the same ETH into Uniswap V3’s liquidity pools, we are ‘long’ on ETH. This means we stand to benefit from potential fee earnings generated from the liquidity pool, which could include trading fees from ETH/USDC transactions.
To quantify our approach, we employ the following formulas for supply and borrow on Aave. We supply/Lend N amount of USDC to Aave from the total deposit as collateral, determined by the following equation:
And we borrow X amount of ETH using the following equation:
These equations leverage a 65% collateral ratio for borrowing ETH, providing a structured framework for our approach.
Long with Uniswap V3 Liquidity Pool
Uniswap V3’s Concentrated liquidity feature allows us to set specific price ranges for our liquidity, optimizing fee generation based on market predictions and volatility. By dynamically managing our liquidity and adjusting to market movements, we enhance the potential for favorable returns while maintaining a delta neutral stance.
We use the borrowed ETH(X) from Aave to provide liquidity in the ETH/USDC pair on Uniswap V3.
The USDC amount(Y) to be paired is calculated as:
This liquidity provision is not just about earning trading fees; it plays a crucial role in balancing vaults portfolio. By providing liquidity in ETH/USDC, we essentially establish a long position in ETH. This long position is designed to counterbalance or ‘neutralize’ the short position we’ve created by borrowing ETH on Aave. In essence, we are long ETH through Uniswap V3 and short ETH through Aave, aiming to maintain a market-neutral stance.
The strategic positioning of our liquidity in Uniswap V3 is therefore twofold: (1) to generate trading fees and (2) to create a hedge against our short position. This approach to liquidity provision, coupled with the concentrated liquidity feature of Uniswap V3, enhances our ability to optimize fee generation.
The unused ETH borrowed from Aave will be used to promptly repay the Aave debt after establishing a position on the ETH/USDC Uniswap V3. Through simulation, we observe that the debt ratio consistently remains at 100%, while the collateral ratio is maintained around 65–64%. By targeting a collateral ratio of approximately 67%, the actual collateral ratio should hover around 66–67%.
Auto Rebalance with Auto-Compound
Active management of our strategy’s positions is crucial in maintaining a delta neutral position. To facilitate this, we have developed an auto rebalance algorithm. This algorithm is designed to continuously monitor market conditions and automatically adjust our positions accordingly. Such a proactive approach is vital for balancing the risks and opportunities presented by the market, ultimately aiming to maximize potential returns.
A key component of this algorithm is maintaining the health of our risk exposure on Aave lending and ensuring our Uniswap V3 liquidity pool position remains within an optimal range, thereby minimizing impermanent loss.
We achieve this by using the Debt Ratio as our rebalancing threshold, calculated as follows:
Our algorithm triggers the auto-rebalance when the Debt Ratio reaches a predetermined threshold. The rebalancing process involves recalculating the new deposit amount based on two primary scenarios, which are influenced by ETH price movements and include an auto-compounding effect.
Rebalance When Debt Ratio < 1 (ETH Price Decrease)
In this scenario, we have more ETH than USDC on LP Pool Uniswap V3 which mean our ETH debt is less than ETH in the pool. Upon withdrawing LP position , the ETH in our Strategy vaults exceeds our ETH debt. The action involves repaying the Aave ETH debt then converting the excess ETH back to USDC.
The new deposit amount is calculated as follow:
When the debt ratio drops below 1, our ETH on LPs exceed the debt. This prompts us to swap the excess ETH for USDC after settling the debt. It’s crucial to consider that slippage during this swap will slightly decrease the amount of USDC received
Where:
debt = ETH debt on Aave
Y’ = USDC Amount on LP
X’ = ETH Amount on LP
Fp = ETH price
FeeX = Earned Fees in ETH
FeeY = Earned Fees in USDC
Slippage = Reduction in asset value (e.g., 0.1%) during an asset swap, due to price differences between the expected and executed trade.
Rebalance equations when Debt Ratio > 1 (ETH Price Increase)
In this situation, Our LP pool on Uniswap V3 holds more USDC than ETH. This implies that our ETH debt is greater than the ETH in the pool. Upon withdrawing from the LP, the ETH in our wallet is less than our ETH debt therfor we need to swap enough USDC to ETH to fully repay the Aave debt.
The new deposit amount is calculated as:
With the debt ratio greater than 1, the process involves swapping USDC for ETH. Note that slippage will reduce the final ETH amount received.
Once the new deposit amount is determined, we restart the process: lending and borrowing on Aave, then providing liquidity to Uniswap V3. This cycle is repeated, enabling adaptation to fluctuating market conditions.
This auto-rebalance, with its auto-compounding feature, is integral to our strategy, enabling swift adaptation to market changes and maximizing investment growth, all of which reflected to nUSDC price. By automating the rebalancing process with compound growth considerations, we aim to maintain an optimal delta neutral position, effectively managing risk and aiming for consistent, compounded returns.
Mechanics
Our Concentrated Liquidity strategy capitalizes on the capabilities of concentrated liquidity DEXs, like Uniswap V3, in conjunction with lending protocols to construct an effective LP position.
The process involves the following steps:
- $USDC is allocated to strategy.
- A portion of USDC is deposited to AAVE and used as collateral to borrow $ETH.
- Remaining USDC is paired with ETH to create an LP on Uniswap V3.
- Use any unused assets (refunds from Uniswap) to repay part of the Aave debt.
- Automatically compound earned fees during each harvest, which is reflected in the nUSDC price.
Backtesting
In refining our Uniswap V3 Delta Neutral Strategy, a key focus has been on mitigating impermanent loss (IL) and optimizing overall performance. The success of our strategy hinges on accurately calibrating two critical settings: (1) Tick Spread and (2) Debt Ratio.
Testing Approach:
To find the optimal settings, we engaged in a comprehensive backtesting process:
- Debt Ratios Tested:
We experimented with five different debt ratios: 2.5%, 5%, 7.5%, 10%, and 12.5%. - Tick Spread Tested:
Each debt ratio was paired with five Tick Spread: 5.0%, 10.0%, 15.0%, 20.0%, and 25.0%.
This approach resulted in 25 unique combinations, offering a broad spectrum of scenarios for analysis.
Our core objective during this testing phase was to identify the most efficient combination of Debt Ratio threshold and Tick Spread. The aim was to maximize Annual Percentage Yield (APY) and Assets Under Management (AUM) while minimizing drawdown.
Result
Our extensive testing, which involved 25 unique combinations, generated approximately 260,000 data points. These data points were instrumental in providing insights into the performance of each combination under various market conditions.
By analyzing and visualizing the data through charts, we were able to discern patterns and trends. These insights are critical in our decision-making process, helping us fine-tune our strategy for optimal performance.
Given the sheer volume of results, it was essential to distill the information into a more manageable form. We decided to focus on the top four combinations, which consistently outperformed the others across multiple metrics.
Evaluation Criteria
To ensure a fair and objective evaluation of each strategy, we established a scoring system. This system took into account several key metrics, each normalized to allow for direct comparison:
- Normalized Value Formula:
Using the normalized values, we then calculate a composite score for each strategy:
- Composite Score Formula:
The top five strategies, based on the highest composite scores, were selected for a detailed analysis.
Top-performing strategies:
Where:
D = DebtRatio
r = TickSpread
Detailed Metrics Overview:
The charts below offer a visual representation of each strategy’s performance across key metrics: APY, Drawdown, AUM, and Rebalance Count.
The APY chart reveals initial high volatility across strategies, with sharp declines observed in some cases before they stabilize. Over time, the APYs converge, indicating reduced volatility and potential market adaptation. The 7.5 debt ratio and 15 tick spread strategy consistently shows a higher APY, pointing to its effective balance of risk and return.
In the drawdown chart, all strategies experience temporary declines, possibly linked to events like the USDC depeg. These drawdowns vary in severity and frequency, mirroring the APY volatility and highlighting the inherent risks. As the period advances, certain strategies, notably the one with a 7.5 debt ratio and 20 tick spread, exhibit less severe drawdowns, hinting at a more stable or conservative risk management approach.
The AUM growth chart shows a positive trend across all strategies, reflecting successful asset accumulation. Diverse growth rates and patterns across different strategies underscore their individual performance. The strategy with a debt ratio of 7.5 and a tick spread of 15, in particular, exhibits strong growth.
The rebalance count bar chart displays the frequency of position adjustments per strategy. A higher count in strategies like those with a debt ratio of 7.5 and tick spread of 15 indicates more active management. Conversely, lower counts, such as in the strategy with a debt ratio of 12.5 and tick spread of 20, suggest a more passive approach or broader adjustment thresholds.
Initially high APY volatility and drawdowns suggest risk, but over time, these stabilize, aligning with long-term goals as seen in strategies like D7.5r15 and D7.5r20. In terms of AUM growth, higher rebalance counts don’t always yield better results, underscoring the importance of strategic rather than frequent rebalancing.
Now, let’s delve deeper into the numbers:
Analysis
Returns (APY)
- D5r20: Solid average APY of 4.70%, suitable for moderate, consistent returns.
- D5r25: Lower APY of 2.47%, more conservative with wider tick spread.
- D7.5r15: Respectable 4.55% APY, balancing leverage and risk.
- D10r10: Average APY of 3.57%, moderate returns at higher leverage.
- D12.5r20: Lowest APY at 2.43%, cautious, stability-focused strategy.
Risk (Drawdown)
- D5r20 and D5r25: Moderate risks with -0.55% and -0.57% drawdowns, respectively.
- D7.5r15: Lowest drawdown at -0.45%, indicating stability.
- D10r10: -0.51% drawdown, moderate risk at higher Debt Ratio.
- D12.5r20: -0.53% drawdown, cautious risk management at highest Debt Ratio.
Operational Costs (Rebalance Count)
- D5r20: 493 rebalances, moderate operational costs.
- D5r25: 337 rebalances, most efficient operational profile.
- D7.5r15: 408 rebalances, efficient at higher Debt Ratio.
- D10r10: 534 rebalances, frequent adjustments needed.
- D12.5r20: Least rebalances at 121, minimal adjustments needed.
Assets Under Management (AUM)
- D5r20: AUM of $105,313.38, effective at moderate Debt Ratio.
- D5r25: Similar AUM of $105,310.40, stable with wider tick spread.
- D7.5r15: Highest AUM at $105,659.86, effective with mid-range tick spread.
- D10r10: AUM of $105,339.77, moderate growth at higher Debt Ratio.
- D12.5r20: Lowest AUM at $104,753.51, challenges at highest Debt Ratio.
Summary
- D5r20 and D5r25 are balanced, suitable for stability and reasonable returns.
- D7.5r15 excels in return, risk management, and operational efficiency.
- D10r10 and D12.5r20 are conservative; D10r10 requires active management, while D12.5r20 focuses on minimal costs and lower risk at high Debt Ratio.
Conclusion
Our backtest results have shown that this strategy effectively minimizes market exposure, delivering stable returns even in volatile conditions. However, we acknowledge the potential to further refine and optimize the parameters. We are taking a little bit more time for research and development to perfect our newest delta neutral strategy. We’re committed to getting it just right, so we have not finalized the parameter settings yet. Keep an eye out for our next announcement, where we will reveal the optimized settings before the strategy’s official launch.
Our strategy is designed as a safer and more stable option, surpassing traditional stablecoin staking and conventional liquidity provision on Uniswap V3. We aim to offer higher potential profits with minimized risks commonly found in liquidity pools. This innovative approach allows you to invest in top-tier protocols on Arbitrum confidently, ensuring greater stability and lower market exposure.
Stay relaxed and tuned, Neutrons ☕️
Neutra Finance
Neutra Finance aims to make risk-hedged, sustainable investment strategies easily accessible for anyone, anywhere, through automated strategy vaults. We strive to make this process simple and easy so that anyone who wants to protect their funds and earn stable returns can do so in any market condition.
Upon depositing your capital into our vaults, you can sit back and earn APY above-market standards on high-performing DeFi products while the strategy will do the rest.
If you have any inquiries, feedback, or partnership proposals feel free to contact the team via Discord or Marketing@neutra.finance !
Official Links: 🏠 Website | 💬 Discord | 🐦 Twitter | 🌐 Telegram | 📄 Documentation
