We Need On-chain Hedging

Crypto suffers a liquidity problem. So much so, projects often times sacrifice the decentralization of their project to make under the table deals with centralized market makers to bootstrap a sufficient amount of liquidity.

A large reason for this is poor risk management in crypto. Market making comes with a lot of risk and so they require tokens or other forms of incentivizes to offset the risks.

Traditionally sophisticated market makers would mitigate this risk by hedging with non-linear derivatives.

Unfortunately in crypto, derivatives have consolidated to one dominate instrument — the perpetual future. An easy to manage financial contract that offers traders pure leverage exposure. So let’s say you think $ETH will go through the roof. Well with a “perp” you can make a bet on the delta or direction with 10x and sometimes 100x leverage. For market makers or sophisticated actors this is not sufficient for hedging. Complex assets like Uniswap LP shares have complex risk profiles. These LP share are analogous to a replicated option portfolio. Like an options portfolio, LP shares have gamma risk. That means for a market maker, they are taking a directional view on volatility when they provide liquidity on Uniswap.

To hedge this volatility exposure, it requires derivatives with non-linear payoffs often exhibited in options.

As the saying goes, “to hedge an option, you need an option.” — someone

For a market maker, they are limited to a few centralized venues such as Derbit and Opyn (which offers a option-like product in Squeeth). These venues are arguably the only liquid venues for non-linear contracts in all of crypto. And Squeeth, well, only offers the exposure on ETH.

Simply put, liquidity providers on-chain do not have the resources to hedge across all tokens and different portfolios. Thus leaving to on-chain finance with a huge liquidity shortfall.