Diamond Protocol
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Diamond Protocol

Introducing: Diamond Protocol’s Perp LP Strategy

Introducing: Diamond Protocol’s Perp LP Strategy

Description

Providing liquidity in Uniswap V3 needs active management. Our goal is to build vaults to help you maximize fees by range selecting, minimizing IL (Impermanent Loss) by rebalancing, and protecting you from aggressive price fluctuations. Also, this strategy will benefit from Perpetual Protocol’s liquidity mining rewards and the low gas of Optimism Layer 2.

Liquidity Providing on Perpetual Protocol V2

Perpetual Protocol V2 (Perp) uses a virtual AMM mechanism nearly the same as Uniswap V3 for providing liquidity. Anyone can deposit USDC into the Perp vault and open a range order to provide liquidity and earn trading fees, but that also means you will suffer the IL either the price goes up or down.

We got all transactions of the Perp ETH market and calculated the earned fee each day since inception (2021/11/27 to 2022/4/27) and calculated an average of $9018 in earned fees per day. We used the fee data to simulate the APY for a range order, with the max and min prices being +-10% of the market price. We can get a 90.62% fee APY. At the same time, Perp provides 5000 PERP tokens for each market each week as a reward, and it can generate an extra 28.71% reward APY. Therefore, the total APY will be 119.33%.

IL vs. Fee

The above chart showcases the simulated “IL vs. IL + Fee” of providing $1000 for 30 days in the ETH market with the +-10% range. We used a combined 119% Fee APY which consists of 90% Fee APY + 29% Rewards APY. The chart describes the case that all prices all in range during the period. If the price falls out of the range, there will be no fee income plus IL.

You can see the break-even points are when the price goes up or down 9%, so how to prevent you from losing money when providing liquidity? There are two approaches:

  1. Rebalance before the price goes so high or low, which means you remove your liquidity, realize the IL, and provide your liquidity with a new range order.
  2. Hedge the IL with some financial instruments like call or put options.

Design Strategies

Rebalance

When providing liquidity using the Uniswap v3 mechanism, the narrower your range, the more fees you will earn, however, you will suffer more IL when the price changes out of range, which means you need to rebalance more often to avoid the loss caused by substantial price changes.

Therefore, most liquidity providing strategies fall into these two categories:

  1. Provide liquidity with a broader range e.g. +-20% (default strategy of Perp) and seldom rebalance. The fee income is lower, but the IL curve is smoother.
  2. Provide liquidity with a niche range and rebalance very often. The fee income is maximized, but the IL curve is steeper.

Hedge IL

The IL is not easy to be fully hedged, but if we can hedge the IL when the market price exceeds the range, we can create a risk-neutral strategy. The instruments that we can use are the options. We can buy a call option and a put option to generate profit to offset the IL when the market price exceeds our range. Therefore we proposed some strategies below.

Our Strategies

Strategy A — Liquidity Providing with Strangle

This strategy provides liquidity in the range of +-10%, and we purchase a call and a put option that are both out of the money options (OTM).

In TradFi, this options trading strategy is usually called a Strangle, and by creating strangle, we can make a payoff curve that can generate profit under almost any price change. When implementing this strategy, we periodically rebalance the range and purchase new options when the options expire.

In terms of longing volatility, a straddle is another strategy that has been frequently used in TradFi. But we chose to stick with the strangle for the following two reasons:

  1. The incurred IL is non-linear. When the price movement is relatively small, we can live with the IL, so we do not need to hedge from our entry price.
  2. Constructing a straddle is much more expensive than strangle, thereby reducing the expected return in this strategy.

Strategy B — Liquidity Providing with Buying Call or Put Option

This strategy also provides liquidity in the range of +-10%, but we only purchase either a call or put option in this strategy. We also periodically rebalance the range and purchase new options when options expire when implementing this strategy. This will create an interesting curve similar to the Covered-call or Put-selling approach but with nearly half the downside risk.

The graph below compares our liquidity-providing strategy with a call option vs. the plain vanilla covered call strategy given the exact conditions of the option, including tenor, strike price, and premium. And as the graph shows, this strategy outperforms the plain vanilla covered call strategy at almost any given price. Furthermore, we suffer approximately half the downside risk when the price goes up.

Similarly, the graph below compares our liquidity-providing strategy with a put option and the put selling strategy. Again, as the graph shows, this strategy outperforms the put selling strategy at almost any given price, and it also provides better downside protection when the price goes down.

Strategy C — Liquidity Providing with Rebalance Only

You might ask, can I just provide liquidity in the range of +-10% without any hedge positions? But according to the price fluctuations of crypto, you can’t stay in this range forever, so you will need to rebalance.

Here, we provide a strategy that rebalances periodically with no hedging positions. In a crab market, which means the market fluctuates but keeps returning to some baseline, our fee income should be higher than the above two strategies. However, since there’s no hedging position, this strategy will still suffer huge IL and earn no fee income when prices fluctuate.

Summary

We are building the strategy with the Perp team to offer on-chain vaults with the strategies above. You can easily deposit USDC and earn fee + PERP rewards, perhaps with some more benefits. With more innovations that Perpetual Protocol v2 will offer, like Multi-collateral, we think their trading volume will keep growing, and the fee income will be even higher. We will open the vault for beta soon. Stay tuned to our Twitter and Discord.

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