Superfluid collateral for squeeth in the Uniswap pool
Superfluid means you get to do more stuff with your collateral. In the squeeth ecosystem this is enabled by allowing Uniswap v3 LPs to be collateral for short squeeth. This means that
- You can earn yield on short oSQTH collateral, and
- You can take active bets on ETH and oSQTH by changing the composition of your LP.
But what exactly is the exposure when you mix squeeth and ETH with Uniswap v3 LPs? And when should you do it? And if you do it, should you mint the oSQTH first or just buy it with ETH?
In this paper we work through some results and intuition.
Here are the highlights:
- It’s at least as good to have Uniswap v3 collateral as ETH collateral (since a v3 LP can be 100% ETH)
- It makes sense to hold an in-range LP as collateral if you expect trading fees to be higher than one eighth of the annualized variance of ETH/USD
- Minting oSQTH to LP acts as a loan of oSQTH and a hedge of ETH
- You can use a uni v3 LP to tactically trade between oSQTH and ETH, so it’s possible to run an active trading strategy inside your collateral
If you just want the math and code check out the full paper here.
Why should you LP in a Uniswap pool in the first place?
When you LP in a Uniswap pool the value of the LP is a function of the square root of the price. It looks like the blue line here
If there were no trading fees, the LP (blue) would be strictly worse than a long position (red). The difference is sometimes called “impermanent loss”. A useful rule of thumb is that the trading fees need to be higher than one eight of the variance to compensate for impermanent loss (check out our paper here for the details). If you think that the fees are going to be higher than that, it makes sense to LP in the pool.
For example, if you expect the annualized volatility of eth/usd to be 90%, fees need to be at least 0.9²/8 = 10.125% per year for the LP to be profitable. If the pool is $5m with a 0.3% fee this means at least $462,329 of trading volume per day.
We can summarize in a trading rule:
LP trading rule: If you are short oSQTH and currently have only ETH collateral, you should switch collateral to a uni v3 LP if the trading fees are higher than 𝝈²/8 where 𝝈 is the ETH/USD volatility.
Should you mint + LP or buy + LP in the oSQTH/ETH pool
The squeeth mechanism allows you to deposit oSQTH/ETH Uniswap LPs as collateral to back minted oSQTH. The minted oSQTH is effectively an interest free loan from the contract. This means two things:
- Minting to LP leverages the returns of a Uniswap LP. If the oSQTH is half the value of the pool you get 2x leverage compared to just LPing normally
- Because you are long oSQTH in the pool and short oSQTH from minting it, you have a lower exposure to oSQTH. For a full range LP this hedge is exact and you get a maximum value in ETH if price stays the same (see figure below — the ETH value of the LP is highest at the current price)
The mint + LP route gives am initially 2x leveraged delta hedged position in ETH, or higher for a uni v3 LP with concentrated liquidity.
Leverage can be good or bad, depending on your risk preferences, but it’s good to have the option. If the pool is paying 0.1% in fees each day and you think the true volatility is 90% your expected APY from buy + LP is 26% or 52% from mint + LP.
The LPLab spreadsheet shows how this works for the buy + LP and mint + LP cases for Uniswap v3 range LPs.
Tactical trading with ControllerHelper
Later this month we are releasing a new contract (ControllerHelper) to help manage short positions with functions to atomically manage collateral in a squeeth vault. This enables more flexible trading since it is possible to liquidate a v3 LP, trade in the pool, and deposit into a new LP all in one transaction.
Tactical trading within uni v3 LPs
Uniswap v3 concentrated liquidity LPs can be used tactically to hold a combination of ETH and oSQTH. If the pool price is below the lower bound, 100% will be in oSQTH and above the upper bound 100% will be in ETH.
A trader might see a jump in the oSQTH price relative to ETH due to a large trade in the pool. The trader can execute the following trade flow:
- Withdraw the collateral LP and remove the ETH and oSQTH
- Sell some of the oSQTH into the pool for ETH
- Deposit the remaining oSQTH and ETH in a new LP
Later when the oSQTH price in the pool returns to fair value, the trade can be reversed.
Concentrated liquidity as limit orders
A trader might want to execute a large trade between oSQTH and ETH. The trader constructs a concentrated liquidity v3 position with a one tick range, 100% in oSQTH near to the current pool price. Any trade buying oSQTH and selling ETH will transact against this LP, effectively making a limit order to sell oSQTH at a particular price.
Superfluid collateral and the squeeth ecosystem
Superfluid means you get to do more stuff with your collateral. One part of this is that you get to earn trading fees on collateral, which is nice. More importantly it means you can tactically position your full collateral amount between 100% oSQTH to 100% ETH. This means that your collateral pool becomes a powerful weapon in your trading arsenal.
Superfluid collateral makes the squeeth ecosystem more sustainable, since collateral backing squeeth can also back liquidity and risk capital for the system. Relative value, arbitrage, and trading fees can accrue to squeeth creators, all while improving liquidity and price discovery for everyone. That’s super cool.
