Strategic Yield Optimization in AMMs

A deep dive into how AMMs offer a unique blend of opportunities and challenges for institutional investors

Automated market makers (AMMs) have revolutionized DeFi by providing an innovative mechanism for exchange assets without the need for traditional entities to create a market. As the first widespread method for users to earn yields in the DeFi space, AMM pools have become a foundational component. These pools allow liquidity providers to deposit pairs of tokens into a shared pool, which is then used to facilitate trades between those tokens based on a pre-set pricing algorithm. In return for providing liquidity, participants receive transaction fees generated from trades within the pool, effectively earning yield on their staked assets. This introduction of AMM pools marked a significant departure from traditional finance models, emphasizing the unique capabilities and autonomy DeFi offers to individual investors.

IntoTheBlock’ AMMs Offering

In 2020, we began exploring quantitative strategies based on these mechanisms to our institutional clients through our Smart Yields Service. This move marked our initial foray into leveraging DeFi innovations for institutional-grade investment solutions. By initially integrating AMM-based strategies, we provided our clients with a novel approach to earning yields through liquidity provision. Since then, we have continuously expanded and refined our offerings. Today, our suite offers strategies in more than 200 liquidity pools across 10 blockchains, also incorporating our advanced risk management tools and algorithmic adjustments to optimize returns. This evolution reflects our commitment to staying at the forefront of DeFi investment opportunities, continuously seeking innovative ways to serve our clients’ needs in a rapidly evolving market.

Our primary goal is to provide access to DeFi strategies that present an enticing financial profile, effectively balancing the dual objectives of maximizing returns while minimizing risks. To achieve this, we have curated a broad spectrum of liquidity pools that cater to varying degrees of financial appetite — from conservative strategies designed for risk-averse investors to more aggressive approaches for those seeking higher yields. This diverse offering ensures that each institutional client can find a strategy aligned with their specific risk tolerance and return expectations.

Yield Sourcing Logic And Rebalancing

Our DeFi investment strategies primarily generate yield through two key mechanisms: trading fees and liquidity mining rewards.

• Trading Fees: When liquidity providers deposit their assets into an AMM pool, they enable the pool to facilitate trades between different tokens. Each trade incurs a fee, a portion of which is distributed to the liquidity providers proportional to their share of the pool. This fee accrual mechanism serves as a direct incentive for providing liquidity, offering a steady income stream based on the volume of trades executed within the pool.
• Liquidity Mining Rewards: In addition to trading fees, many DeFi platforms incentivize participation through liquidity mining. This involves distributing additional tokens to liquidity providers as rewards for staking (or temporarily locking) their assets in a pool. These rewards often come from the protocol’s own token reserves and are intended to encourage more users to deposit their funds, thereby increasing the liquidity and stability of the platform. The value of these rewards can vary significantly, influenced by the market price of the distributed tokens, the total amount of liquidity provided, or changes in the supply of tokens allocated to the liquidity mining campaign.

To maximize the yield from these sources, we employ an efficient automatic rebalancing algorithm. This algorithm optimizes the timing and size of rebalances to take advantage of compounding rewards while considering the gas prices on each blockchain. Gas prices, or the fees associated with conducting transactions on a blockchain, can vary greatly and impact the cost-effectiveness of frequent rebalancing. Our algorithm dynamically adjusts, ensuring that rebalancing occurs in a manner that enhances overall returns without incurring excessive transaction costs. This strategic approach helps in accumulating and compounding yield efficiently.

Opportunity Detection

Detecting the most lucrative opportunities within DeFi requires sophisticated on-chain monitoring systems to detect rapidly strategies that offer excessive returns and strategic evaluations of the risk profile that each of these strategies present. Here’s how we extensively analyze potential strategies:

• Real-Time Tracking System: Our advanced real-time tracking system monitors a vast array of DeFi protocols and blockchains. Currently 25 chains and over 100 DeFi protocols, which generate around 800 different investment opportunities, about 100 of them are composed of AMM pools strategies. By continuously aggregating data across multiple sources, our system ensures that we have a granular and up-to-date understanding of the DeFi ecosystem and its dynamics over time.
• Pareto Efficiency and Market Benchmarks: We employ the concept of Pareto efficiency to evaluate the most productive strategies. Each pool has its own unique risk/reward profile based on the assets it contains, the protocol it pertains to, its liquidity deposits, etc. A pool that is Pareto efficient stands out in that no other pool can offer a better risk/reward ratio for the same type of asset or investment without increasing risk or reducing reward. This is complemented by our use of market benchmarks rates, which provide a comparative baseline against which the performance of various DeFi protocols can be assessed. These benchmarks are crucial for distinguishing between genuinely superior yields and those that are standard due to the current situation of the market.
• Yield Longevity Evaluation: A critical aspect of our strategy validation process involves assessing the sustainability of yields, which often decay over time. Our analysts scrutinize historical on-chain pool data and coin pricing trends and market dynamics to predict how long a high yield is likely to last before it begins to decay, enabling more strategic planning around entry and exit points.
• Capacity Constraints and Yield Dilution: DeFi protocols can suffer from capacity constraints when deploying at scale. As more investors contribute liquidity, the return on investment dilutes. This dilution occurs because the incremental yield generated by additional liquidity diminishes as the size of the pool grows. Our strategies are designed to identify and prevent as much as possible the impact of yield dilution. By depositing up to certain amounts we assure that the yield generated by the strategy remains above market benchmark levels.

Real time pools dashboard displays the APY earned vs the deposit capacity it allows to keep up to a 10% pool share.

Strategy Lifecycle Risk Management

In our DeFi investment approach, managing risk in each of the potential and deployed strategies is a multifaceted process. It involves meticulous evaluation before entering a position and vigilant monitoring once deployed. Here’s an extensive explanation of the process we follow during the evaluation and deployment of each strategy we offer:

Multilayered Risk Evaluation Process

Strategy Pre-Entry Pool Evaluation

Multilayered risk factors exploration: we follow a top to bottom approach, where the blockchain where the strategy will be deployed is the first point of analysis. This is followed by an evaluation of the pertaining DeFi Protocols and the economical or technical risks that it might possess. Next is an analysis of the specific set of risks that the analyzed pool might present. Lastly the underlying coins that are deposited into the pool are evaluated. If at any point of the pipeline a significant risk factor arises, then the process halts, the strategy is invalidated and at the end not included in our offer.

• Blockchains: Each blockchain carries its own set of risks, including potential centralized points of failure and infrastructure risks that might impact the blockchain’s liveness. Such risks could prevent us from executing timely risk management actions. For instance, network congestion can delay transactions when execution is crucial.
• DeFi Protocols: We analyze the topology of each DeFi protocol to understand where risks might lie. AMMs generally have a different risk profile compared to other DeFi constructs like lending markets. Historically, AMMs have been economically safer due to their simple liquidity provision mechanisms and lower exposure to insolvency risks, or technical complexities. The technical readiness of the protocol is also evaluated here, carefully examining the existing auditories executed over the protocol, as well as a technical readiness check from our blockchain engineering team.
• AMM Pools: In this stage we assess the underlying mechanics of the pools. Pools with a significant imbalance between paired assets might suffer from high price impact costs if a large position needs to be unwound. This can lead to considerable financial loss during critical market conditions.
• Underlying coins: The leading factors that might impact largely in the market pricing of the coin are assessed in this state. Factors such as tolerance to liquidity crunches or endogenous minting/redeeming properties inherent to each coin are evaluated in this last stage.

Yield Sustainability Analysis:

• Coin Price Volatility Analysis: We assess the volatility of the underlying assets in a pool. High volatility can affect the stability of expected yields and the overall risk profile of the strategy. The historical market price volatility of the rewarded token (in case of existing an active liquidity mining campaign) are also analyzed here.
• Liquidity Mining Campaign Evaluation: This involves analyzing the terms and duration of liquidity mining incentives. Temporary boosts in yield through token emissions can significantly affect the sustainability of yields once the incentives end.
• Trading Fees Volatility: Since a portion of returns from AMM pools derives from trading fees, we evaluate the historical and expected future volatility of these fees. Variable trading volumes can lead to fluctuating fee returns, impacting the overall profitability of the pool.

Post-Entry Pool Risk Management

Once a strategy is deployed, the real risk management begins. We continuously monitor both on-chain and off-chain risk factors through real-time systems designed to alert our team to changes in market dynamics or operational issues arise, as well as automatically disassemble the position as fast as possible while minimizing exit risks if the conditions are critical. These include:

• Liquidity Flows Dynamics: This refers to the monitoring of the total inflows and outflows within a pool, providing a net picture of liquidity movement. Understanding these dynamics helps predict potential liquidity shortages or surpluses, which can the realized costs when disassembling positions.
• Arbitraging Activity: Measures the extent and frequency of arbitrage trades, which exploits price discrepancies between markets. Monitoring this activity helps in assessing market efficiency and liquidity. Frequent arbitrage may indicate significant price volatility or inefficiencies, which could pose risks to stability and predictability in pool values.
• Price Peg Monitoring: Tracks how closely an asset’s price adheres to its intended peg and how quickly it returns after deviation. This metric is only applied for those pools that contain coins that must trade at a pegged price. Monitoring helps manage the risk of sudden devaluations, which can affect collateral stability in lending protocols.
• Liquidity Depth Profiling: Evaluates the pool’s ability to handle large transactions without significant price impacts. Deeper liquidity implies that larger trades can occur with minimal slippage, enhancing market stability and reducing the risk of market manipulation.
• Exit Fee Assessment: Analyzes the potential impacts of significant withdrawals, especially by large stakeholders. This assessment helps understand and prepare for the potential market consequences of high-volume liquidity removals and swaps into one of the underlying coins, which could lead to increased realized costs when disassembling the position if not managed correctly.
• Concentration Metrics: Tracks the degree of liquidity concentration from specific entities such as major protocols and large individual investors within the liquidity pools. Monitoring concentration metrics is essential to assess the risk of dependency on major players. High concentration from a few sources can signal to potentially be exposed to the imbalancing mechanics of the pool’s trading function after these entities swap out their coins. This could significantly affect liquidity and price stability if they decide to withdraw or shift their strategies. This indicator helps in assessing the diversity of participation and balancing the influence of large stakeholders to maintain healthy concentration levels.

All of these indicators can be seen live in our Risk Radar Portal, in this case specifically for Curve Finance AMM. If the reader is interested in learning more deeply about each of these indicators, we wrote a complete article about it last January.

This comprehensive approach ensures that each strategy is backed by a robust and strict risk management framework designed to safeguard assets while striving for optimal returns. This diligent process not only helps manage the inherent risks of DeFi but also positions us to take quick and proactive steps in response to changing market conditions. By continuously enhancing our algorithms and risk management protocols, we aim to provide our clients with the most sophisticated and secure investment opportunities in DeFi. This forward-thinking approach ensures that we stay at the forefront of a rapidly changing industry, ready to adapt and capitalize on new developments as they arise.