Uniswap V3 LP is essentially shorting volatility

In the current high volatility phase of the market, Uniswap V3’s liquidity providers are exposed to greater risk.

Uniswap V3 liquidity providers are at greater risk during the current high volatility phase of the market.

Summary.

The author believes that Uniswap V3 would be better named Uniswap PRO. The author’s view is that V3 is not an upgrade of V2, but a completely different attempt and that both products should exist together to capture their respective markets.

V3 is a fascinating product with some option-like properties, even a “seller’s option to earn time gain (Theta)”. Researchers on V3 suggest some additional concepts on volatility.

The second half of the article shares some ideas for setting up V3 LP trades with covered calls/puts.

Finally, there are some concerns about V3 liquidity gathering.

V3 might be named Uniswap Pro
Uniswap V2, or the previously released Uniswap product, features Pool to People or Open Finance, where the user injects $100 into a liquidity pool and the pool has $1 billion in funds that are not fundamentally different, converging into a public market-making pool, which earns The fees earned by the pool are distributed to each participant in proportion to the provider’s share. All funds are used with exactly the same efficiency, solving the problem of long-tail assets as long as they have quotes to exchange for assets.

The liquidity aggregation design of V3 is completely different, and the liquidity providing credentials are changed to NFT Token, the reason is that each LP sets a different interval for doing business, which is non-standard. As a result, the width of different intervals is different and the efficiency of using funds varies. From the starting point V2 is to provide the long-tail market can exchange, while V3 for the liquidity of the head of the transaction to improve the efficiency of the use of funds and lower slippage biased professional pursuit of products more professional. Therefore, I believe that V2 and V3 are two different positioning products, will continue to go on in parallel to occupy different product positioning on DEFI rather than upgrade the relationship of substitution.

V3 features and volatility
Most of the views have already stopped at discussing the quantitative characteristics of V3, based on the views shared previously this article will go deeper to discuss the relationship between V3 and volatility, as well as the market game views. It is known that V3 for V2 replaced the interval liquidity aggregation, in the price of non-stop stochastic fluctuations in the process of running out of the process of setting the interval will be subject to greater gratuitous losses, as shown in the figure below.

Uniswap V3 LP is essentially shorting volatility

The V3 interval curve is in blue and the V2 curve is in green.

So essentially, V3 is a compression of the price volatility tolerance range to reduce the liquidity segment interval to obtain the enhanced efficiency of capital use.

Uniswap V3 LP is essentially shorting volatility

As shown in the chart above the liquidity segment of the USDC/ETH pair V3: the vast majority of it is clustered in the middle, indeed showing the characteristic of liquidity clustering around the intraday price. This reflects the fact that V3 has lost its resistance to price volatility in exchange for efficient use of capital.

In other words V3 is essentially short volatility in exchange for more premium. Similar to an option product that sells volatility for premium.

About V3 and Volatility
As the price fluctuates randomly, the transaction price gradually runs out of the set range will gradually increase the unpaid loss or even make the trading pair only one currency hedge how to deal with it? The option seller (market maker) will generally do dynamic hedging of the position – hedging back to near neutral exposure as the price fluctuates.

V3 does a similar option dynamic hedge by constantly following the price to adjust the LP NFT range. The optimal frequency of adjusting LP NFT is a balance between V3’s market making fee revenue, real-time price fluctuations (the size of the uncompensated loss) and GAS fees, since every LP NFT adjustment transaction on Ether requires a fee.

Under the assumption that V3 handling fee revenue is fixed, the higher the GAS cost, the fewer adjustments the better, and the greater the price volatility, the more adjustments the better, so the frequency and size of adjusting LP NFT depends on the balance between price volatility and GAS cost. The balance of frequency and granularity is mainly affected by ETH volatility. Non-ETH pairs need to additionally consider the exposure to the impact of ETH price volatility on GAS.

As can be seen above, the choice of adjustment scheme is still based on the forecast of the (future) price volatility of the pair. In addition to quantitative financial engineering approaches to volatility forecasting (which will not be expanded here), volatility can also be judged subjectively in the short term. For example, if ETH has recently fallen from about 4000 to 3000 US dollars, then if I assume that the author subjectively judges that around 3000 will do a small range oscillation, this is actually my subjective prediction of future short-term volatility back to return / lower, choose to fall down after setting the market between 3000-3500 range. If the market is consistent with the author’s hypothetical subjective opportunistic judgment this hypothesis will get in this range of doing gains.

This leads to another point of view of the author: V3 LP hedging program: quantitative volatility forecasting and subjective opportunistic LP concept.

This is a new concept that is completely absent in V2 static market making, and both ways are Alpha, see the program of each team is not the same. So I think V3 is the subjective Alpha gain to hit the giant whale static like the first shot.

Through their own or the team’s efforts can improve their Alpha earnings, enhanced capital utilization is equal to get a lever to V3. In this way, the project based on V3 upper layer belongs to quantitative services or subjective trading services rather than machine gun pools, even contrary to the concept of machine gun pools. In addition, I think the V3-based service provider’s project for the time being, I think the options experience team will be more advantageous, similar to the Charm project is also paying close attention.

Practical V3 trading strategies
The concept of opportunistic LP was mentioned above, and below we demonstrate the application strategy of opportunistic LP.

A strategy like covered call (put) options
To explain briefly, a covered call option is a combination of having spot in hand and setting a target price to sell (buy) the option. For example, I have 1ETH and I want to sell it at 4500USD. Then I get 4500USD plus the option to sell the 4500USD call. When the price reaches 4500 or higher the buyer takes my ETH and my gain is 4500USD + the premium of the sold option. This gives some gain enhancement for the planned 4500 buyout price.

On V3 you can do this by assuming the current market is currently at 3500USD for ETH and I want to sell ETH at 4500USD and I set the pair to trade above the market price of 3500USD in the range of 4250-4750. This way, I only need to put in ETH, and when the price fluctuates in the 4250-4750 range, I can get the market making revenue, and when the price is higher than 4250, ETH starts to be sold until it is sold out at 4750. (The average price of selling at this point is about 4500 and not very rigorous calculation) The total gain should be about 4500 USD + market making gain on one side. (Here you can narrow the market making range to get closer to 4500) Reach the predetermined take profit target and then take out the USD LP.

Uniswap V3 LP is essentially shorting volatility

The bottom-selling strategy and so on is shown below for a buying strategy from about 2500 to 3000 USD around 2750. This will not be repeated here.

Uniswap V3 LP is essentially shorting volatility

It is worth noting that try to think about your subjective expectations before injecting liquidity, as well as your trading plan to avoid blind liquidity injections.

Strategies on the depth of the handicap
It is mainly from the other side of the market game. See the chart below, you can see that the depth is completely distributed on the right side of the market price, so it is presumed that either there are a large number of LPs that have not had time to switch and still remain in the previous 4000 range, or there are a large number of LP holders who believe that the price will go back up to the 4000 range, the latter is presumed to be the subjective volatility judgment of opportunistic LP behavior mentioned above. Looking forward to the gradual maturity of V3 LP market making participants in the future, it is speculated that the future LP depth distribution will show a similar scenario to the options position, i.e., the majority of the current market participation in the price judgment.

Uniswap V3 LP is essentially shorting volatility

Here also raises the author’s concern, from the free game conditions due to the free and open market will appear irrational behavior such as the extreme narrowing of the price range only consider the market making returns without taking into account the volatility of the situation, early most of the participants do not understand V3 characteristics need to avoid being led by such blind behavior to produce a wrong judgment.

Liquidity Aggregation Concerns
Regarding the liquidity gathering of the V3 innovation, the current V3 feature is very similar to CEX market making in that the main liquidity is gathered in the market. At this time, if there is a big fluctuation to eat up the liquidity at the marketplace or LP risk control, there may be a bigger price slippage or stampede than V2.

Maybe V3 is more suitable for almost costless LP adjustment interaction on Layer2 will be a different scenario to reach the market making price reaction speed of centralized exchange.

Addendum: At the time of the initial draft, the price of ETH was oscillating around $3,000-$4,000, and had fallen below $3,000 by the time of publication. Liquidity providers participating in V3 should always be aware of changes in volatility to avoid losses.

Uniswap V3 showcases the leading innovation of the Uniswap team and the boundless energy of DeFi. In an open and free DeFi, the Alpha returns from V3 will again be the fuel to disrupt the whale’s static returns leading the scientists as market makers continue to optimize to create better return efficiency. Looking forward to the future, DeFi-based risk control classes, fixed-rate and graded funds and other different directions to try will give DEFI cut out different Alpha and Beta earnings track. There will be different risk and return ratios to choose from on DeFi, and the era of “pot luck” where everyone gets the same return will change.

By Ian Wu, Head of Pre-Play at DFG

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/uniswap-v3-lp-is-essentially-shorting-volatility/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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