Why does Uniswap V3 significantly increase the risk of market making for LPs?

How has the risk assumed by LPs in Uniswap V3 changed compared to V2, and how should investors better understand this risk?

In the early days of Uniswap V3, many of the first LPs who joined the market for V3 enjoyed very high commission rates. However, it didn’t last long, as the whole crypto market suffered a sharp price drop in late May, and many V3 LPs found that not only did all their market-making positions become the lower priced ones, but also the whole positions lost significantly more money in the market volatility compared to their V2 market-making positions.

So, what is the change in the risk taken by LPs in Uniswap V3 compared to V2, and how should investors better understand this risk? In this article, we want to analyze what changes Uniswap V3 will bring to investors, starting from the most basic principles of market-making activity.

From liquidity provider to portfolio manager
How to look at “providing liquidity” objectively is an extremely critical issue. By becoming a liquidity provider (LP) of Uniswap, you will receive a fee for trading, but at the same time you will have to bear the risk of changes in the ratio of different currencies and price changes. Therefore, relying solely on yield as the only indicator for investment decisions is obviously seriously flawed.

So, how can the pros and cons of providing liquidity be more fully evaluated? Here, we suggest that participants switch to a completely new perspective to think about the whole issue. That is, to consider the provision of liquidity as a portfolio management strategy employed by investors.

Such a strategy, on the one hand, does not rely on the subjective judgment of the fund manager to operate artificially and, on the other hand, dynamically adjusts the investor’s holdings based on a fixed algorithm in response to changes in market prices. This new portfolio management strategy, which incorporates the essence of passively managed funds without human intervention and a proactive position adjustment mechanism, has been renamed “active passive asset management strategy”.

In this perspective, LPs are no longer seen as liquidity providers for trading platforms, but as investors who want to preserve and increase the value of their assets. Then, the criteria for evaluating whether they should become LPs will change from a single market-making yield to the expected return of the portfolio and the amount of risk they may take in the investment process.

So, what are the main risks that investors who become such “active passive asset management” funds will face?

Unconstant loss and inventory risk
Choosing a reasonable benchmark for performance evaluation is the most critical prerequisite assumption for assessing the risk-return profile of a given portfolio. To evaluate the risk-return profile of a credit bond, we can choose the interest rate of a Treasury bond without credit risk as the benchmark; to evaluate an actively managed equity investment fund, we can choose the broad stock market composite index for the same period. Generally speaking, the benchmark chosen to evaluate the performance of an investment depends on the best alternative that the investor would have had if he or she had not participated in the investment, which is often referred to as the “opportunity cost”.

So which metric should an investor choose to evaluate this “fund” called LP Position?

Let’s take the ETH-USDC pair as an example. For a long ETH investor, a full position in ETH would be the benchmark; for a short ETH investor, a full position in USD would be the benchmark; for an investor who does not expect significant price fluctuations in ETH, a status quo position without market making would be the benchmark.

Thus, we have constructed four different investment strategies (all with a total initial amount of $1000) as follows

  1. 100% in ETH
  2. 100% USDC
  3. 50% in ETH and 50% in USDC
  4. 50% ETH and 50% USDC to buy “LP Position Fund” to participate in market making

The vertical axis shows the market value of the portfolio at the end of the period, and the horizontal axis shows the different ETH prices that may occur at the end of the period, without taking into account the fees. We can make a functional image of the above four portfolios’ ending market values at different ETH prices at the end of the period.

Why does Uniswap V3 significantly increase the risk of market making for LPs?

As you can see, if the ending price of ETH does not change relative to the beginning of the period ($3,000), the ending market value of the four strategies will also remain the same ($1,000). However, if the price of ETH falls, strategy 2 (hold USD) is the best choice; if the price of ETH rises, strategy 1 (hold ETH) is the best choice.

It is worth noting that if the investor chooses strategy 4 (green line), i.e. buys a fund called “LP Position” for $1,000 to participate in the market, the ending market value of the fund will always be lower than strategy 3 (yellow line), except for the starting point of the price. This difference is often referred to as the “invariant loss”. The Unconstant Loss reflects the expected additional loss to the investor as a result of the active management of this fund, called LP Position, in the event of a price change.

Let’s go back to the investor’s perspective. Assuming that Investor A expects the price of ETH to rise in the future, what risk will Investor A bear if the LP Position fund is purchased at the beginning of the period and the price of ETH does rise?

Why does Uniswap V3 significantly increase the risk of market making for LPs?

Since Investor A purchased the “LP Position” fund, he will be exposed to the risk of unpredictable losses from the fund when the price rises, i.e. the difference between Strategy 3 and Strategy 4. At the same time, since his optimal strategy is to hold his entire position in ETH, the 50% USDC he exchanged for the “LP Position” fund will not be able to enjoy the subsequent gains from the ETH increase, so this part of his position will bring “inventory risk” loss to Investor A, which is the difference between Strategy 1 minus Strategy 3.

Therefore, for Investor A, the inventory risk of buying the LP Position fund for market making is much greater than the risk of unpredictable losses. This leads us to the following conclusions.

For an investor who expects the price of ETH to rise, buying an “LP Position” fund will expose him to significant inventory risk. Therefore, the optimal strategy is to stay away from market-making activities and look for other ETH-based investment instruments (e.g. participating in PoS pledging activities in Ether 2.0). 2.

  1. For investors who expect ETH price to fall, they should also stay away from market-making activities to avoid holding ETH passively and taking the inventory risk of its price falling. The optimal strategy should be to look for stable coin-based financial or mining activities.

For investors who expect the price of ETH to remain stable, it makes little difference whether they hold ETH or USDC (since they expect little price fluctuation between the two). So using both coins to buy some kind of “financial product” to earn income would be a good choice.

But as we just mentioned, buying this fund, called “LP Position”, has a negative net return compared to not buying it (Strategy 4 will always have a smaller market value at the end of the period than Strategy 3). So why would an investor want to become an LP and thus help the trading platform make a market?

The handling fee is a compensation for unpredictable losses
In the above, we ignored the impact of the commission on the ending market capitalization in order to simplify the model. Let’s now reintroduce the impact of fees into consideration and see how different strategies in a real world scenario would change the investor’s ending market capitalization.

Why does Uniswap V3 significantly increase the risk of market making for LPs?

We find that the purchase of an “LP Position” fund to participate in market making makes sense when fees are taken back into account. With the fee income as compensation, the ending market value of Strategy 4 (green line) is finally higher than that of Strategy 3 (yellow line) within a certain price range. The logic behind the purchase of the “LP Position” fund to participate in the market making activity is then clarified: the investor has to take the risk of losing money at the end of the period if the price fluctuates outside the range in order to obtain a positive return within a certain end of period price range.

In other words, a prerequisite for positive returns from market-making activities is the expectation that the end-of-period price of the asset will not fluctuate significantly. If the ending price of an asset exceeds the safe range, then the investor’s portfolio will be exposed to the risk of loss. This is why some people refer to the provision of liquidity for market making as “shorting volatility”.

Uniswap V3 is a risk amplifier
In the above discussion, we have used the classic model of Uniswap V2 as a reference point when evaluating market making activities. However, we know that the latest version of Uniswap, V3, is a much more efficient use of capital, and that the shape of its end-of-period return curve will necessarily be different from the previous V2 version. Let’s update the previous end-of-period return image and introduce Strategy 5, which is the end-of-period return of the “LP Position Fund” offered by Uniswap V3, using the same funds.

Why does Uniswap V3 significantly increase the risk of market making for LPs?

The chart above clearly shows that compared to the previous strategy 4 (Uniswap V2), strategy 5 (Uniswap V3) not only increases the level of return for the investor when the price is stable, but also increases the level of loss for the investor when the end of the period price is out of the safe range. Therefore, Uniswap V3 is both an amplifier of returns and risk for investors, and investors in the V3 version of the LP Position Fund, while enjoying higher returns, are also bound to incur more unpredictable losses when the end-of-period price falls out of the safe range.

High returns inevitably bring high risks, a law that has remained unchanged in finance, even in the world of blockchain.

Shorting volatility is the most dangerous investment strategy in the crypto industry
From the above discussion, it is clear that the basic assumption for liquidity providers (LPs) to be profitable is that the pairs they participate in market making will not experience large price movements during their expected investment period. If this premise is falsified over the investment period, the investor’s ending market value will often be lower than the ending market value of a portfolio of assets that was held at the beginning without market making.

This default assumption of low volatility is ubiquitous in the current cryptocurrency investment industry. For example, we often see annualized returns of over 1000% for certain project mining activities, and behind these extreme returns is often an implicit assumption that the price of the underlying tokens will never change.

After participating in some so-called “high yield” activities, many investors often feel that their final returns do not meet their initial expectations, and even suffer losses. The root cause of this is often not a problem with the project’s yield calculation process, but rather an incorrect ‘premise assumption’ of low volatility.

The crypto industry is still an extremely new investment field, and the price of various products is extremely volatile, so any assumptions about low volatility may cost investors dearly. I am not here to discuss the flaws of the Uniswap V3 model, but rather I believe that the Uniswap V3 version is an extremely important innovation in the industry because it gives investors the power to actively choose to take higher risks and receive correspondingly higher returns. Putting the ultimate choice of risk taking back into the hands of the market is the most important innovation in the underlying logic of Uniswap V3.

However, for the average user participating in V3 market making activities, it is important to understand that this is simply a rebalancing between risk and reward. Don’t simply see someone else’s yield and enter blindly without understanding the underlying risk logic, and end up taking unpredictable losses that you cannot afford.

Article image courtesy of: defi-lab.xyz

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/why-does-uniswap-v3-significantly-increase-the-risk-of-market-making-for-lps/
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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