What is Liquidity Provision?
LP Token (Liquidity Provisioning Certificate) is the corresponding certificate obtained by liquidity providers after providing liquidity to decentralized exchanges (DEX) running on the automated market maker (AMM) protocol. The provided liquidity is generally a combination of two or more assets. In such decentralized exchanges, as the counterparty of traders, they obtain transaction fees from them.
Different decentralized exchanges will have different types of LPs, including:
Providing liquidity on DEXs such as Uniswap V2 and Curve requires liquidity providers to provide bilateral tokens of the trading pairs and become both buyers and sellers at the same time. In most cases, the value of the tokens on both sides is 1:1.
Balancer's liquidity bootstrapping pool will need to provide bilateral tokens, but can be configured in multiple ratios.
Uniswap V3's LP determines the LP token composition based on the current price and the upper and lower price ranges laid out by liquidity.
GMX's GLP is composed of assets of the types and proportions specified in a package agreement, and the asset ratio is anchored as much as possible through an arbitrage mechanism.
Features of LP:
Passive Liquidity - LP is a special type of Maker that cannot actively make quotes, but passively waits for Takers to trade at the current price.
Value Fluctuation/Impermanent Loss - LP is a pool of funds. Users directly click on the pool to execute transactions and exchange assets in the pool according to the algorithm. The proportion and number of tokens in the pool will change accordingly. The assets settled after the liquidity provider withdraws liquidity will have a certain value loss compared to simply holding the tokens in the LP. This loss is called impermanent loss.
Comprehensive risk exposure - LP is often composed of a series of (more than two) assets, so holding LP is equivalent to holding a series of asset portfolios and need to bear impermanent losses.
Web3 is a value exchange network, and transactions are the underlying demand of the network. As the provider and supporter of transaction liquidity, LP can generally obtain relatively generous fee returns. After Uniswap V3 proposed centralized liquidity, LP's static fee income can even reach hundreds of APR.
LP Token is a very good interest-bearing asset. Directly holding LP Token allows investors to have exposure to multiple token combinations at the same time. Due to the existence of impermanent loss, the volatility of LP Token value is lower than that of directly holding tokens. At the same time, since LP can capture direct transaction fee income, as long as the decentralized exchange can operate stably, LP Token can bring continuous returns to investors. In summary, there are also many investors who directly hold LP as a long-term asset allocation.
However, due to the high volatility of LP itself and the preference of investors for low-risk return products, combined with the simplicity of GLP itself compared to other LPs, many derivative financial products have emerged in the GMX ecosystem. This article will take four projects in the GMX ecosystem that attempt to use GLP as the underlying asset to realize on-chain risk-neutral investment products as examples, and explore from the perspective of mechanism principles and on-chain data:
The (dynamic) composability of DeFi assets.
All hedging solutions are fully implemented on-chain and operated publicly, while combining multiple DeFi projects such as GMX (GLP as the underlying interest-bearing asset), Aave, Uniswap, Mycelium (TracerDAO), etc.
On-chain risk hedging solution.
Technical implementation issues of on-chain derivatives.
Hedging solutions and capital efficiency.
The long-term viability of LP as the underlying asset.
The level of returns and long-term viability provided by the liquidity of derivatives platforms.
GMX/GLP Introduction
GMX is a spot and futures exchange, and futures trading is essentially leveraged trading. Similar to DEX based on AMM mechanism such as Uniswap, GMX adopts PMM mechanism similar to AMM, uses Chainlink's oracle to provide input price, and uses GLP fund pool as liquidity, allowing traders to achieve up to 50 times leverage trading on the platform without slippage. Among them, each transaction will set the maximum transaction amount according to the liquidity of the fund pool, and the transaction fee ratio will increase from 0.2% to 0.8% according to the increase in the deviation of the fund pool ratio and the increase in trading volume.
GLP is the liquidity token of the platform's fund pool. GMX provides liquidity for mutual leverage and spot transactions between multiple currencies on the GMX platform. Therefore, GLP is composed of a combination of assets supported by a package of agreements, and can be minted and destroyed by any of the constituent assets; since the platform has continuous transactions between users and fund pools, the asset composition of GLP is dynamic. GLP adjusts the asset composition through the handling fees in the minting and destruction process to anchor the set ratio as much as possible to prevent large-scale deviations in the asset ratio of the fund pool.
Compared with other AMM-based DEXs, GLP on GMX has higher capital efficiency, and since traders as a whole lose money, the entire GLP as a whole, as the counterparty of traders, will make money. However, due to the use of Chainlink oracles to input prices, GMX itself has no way to achieve price discovery, and the overall liquidity of GMX will have a ceiling.
Figure: Current composition of GLP on Arbitrum
GLP's income comes from the GMX platform: GLP minting/destruction, transaction/opening fees on the platform, liquidation and holding fee income, of which 70% will be given to GLP and the other 30% will be given to GMX token pledgers.
Figure: GLP’s commission income and composition
GLP Hedging Solutions
Traditional market making is a high-threshold market. Only institutions authorized by the exchange can participate, and generally have higher returns. At present, GMX uses various settings, including higher opening fees, handling fees, and a certain time delay than general CEX, to protect the interests of LPs. The liquidity providers of the GMX platform can obtain returns higher than the market average. The GLP APR corresponding to the daily platform income is as follows. In the current market, it can still maintain an annualized WETH income of 15%.
Figure: APR corresponding to GLP daily income
At present, GLP, as an excellent interest-bearing asset, has a relatively low volatility due to its basket of assets, but it is still an unstable asset, and its value will deviate greatly under extreme unilateral market conditions. Compared with LPs of DEXs such as Uniswap, GLP will be easier to hedge against multi-asset risk exposure due to its fixed composition ratio, and investors will be more interested in Delta-neutral investment portfolios, which can obtain higher returns with the lowest possible risk. Therefore, many GMX ecological projects have attempted to achieve Delta neutrality through various on-chain asset combinations to bring users investment products based on US dollars or BTC/ETH. Among them, the projects we have observed are (some of which have not yet been launched):
Rage Trade
GMD Protocol
Umami Finance (Phase I product is shut down, Phase II product is not launched yet)
Neutra Finance (not yet launched)
We will break down the solutions of these projects to explore the feasibility and capital efficiency of on-chain hedging.
Rage Trade - Delta Neutral Vault
Rage Trade provides a dynamic hedging solution, which splits the entire product into two parts: Risk-on vault and Risk-off vault. There is a loan relationship between the two vaults (the high-risk vault is the borrower and the low-risk vault is the lender), forming a Delta neutral strategy as a whole. Users invest USDC in two vaults, of which the low-risk vault is USDC-based and the high-risk vault is sGLP as a share. There will be certain value fluctuations, but the vault design goal is to achieve Delta neutrality in the long term.
The high-risk preference vault flash-loans BTC and ETH from Balancer and converts them to USDC on Uniswap. It then borrows USDC from the low-risk preference pool and uses USDC as collateral to borrow ETH/BTC on Aave to repay the flash loan, allowing the vault to hold a short position in ETH/BTC and hedge the price risk of ETH and BTC in GLP. The hedge amount is based on the target ratio set by GLP. The vault will maintain a health factor of 1.5 on Aave (2/3 of the loan). The high-risk preference vault charges 86.6% of the GLP handling fee as income.
The low-risk preference vault will lend funds to Aave to collect returns. At the same time, because it provides USDC for hedging for the high-risk preference vault, it will collect 13.4% of GLP's returns as its own vault income.
Every 12 hours, the vault automatically settles its earnings, updates its hedging position according to price changes, and withdraws the GLP handling income and reinvests it with compound interest. Overall, the APY of the high-risk preference vault is as high as 10.05%, and the APY of the low-risk preference vault is 3.48%.
Currently, Rage Trade’s two vaults have TVLs of 6.79 M (high risk, holding GLP) and 3.35 M (low risk) respectively.
Umami Finance
Umami Finance previously launched USDC Vault, a solution based on Mycelium leveraged tokens to hedge GLP risk asset positions.
Mycelium builds a long-short bilateral fund pool, with leveraged tokens representing the share of the fund pool. The contract is triggered every 8 hours to transfer funds between the two pools according to the real-time price. When the price rises, the funds are transferred from the short fund pool to the long fund pool, and vice versa. In theory, holding leveraged tokens is equivalent to holding a corresponding proportion of perpetual leverage. However, the transfer of funds in this mechanism is achieved through external robot arbitrage, with capital spillover, and the adjustment curve can only be approximated.
Umami uses Mycelium's ETH/BTC leveraged tokens to hedge the ETH and BTC positions in GLP, so it cannot accurately help Umami's Vault achieve hedging when the market fluctuates violently.
However, because Mycelium leveraged tokens cannot achieve accurate hedging, the hedging end eventually suffered irreparable losses when the market fluctuated violently. Ultimately, the team decided to close the strategy and turn to research on other strategies.
Umami's new strategy has not yet released a product, but the core is also based on GMX's GLP to achieve a Delta neutral strategy, which will be closer to GMD Protocol's products, including splitting GLP into three vaults: USDC, BTC, and ETH. The core of the strategy is internal net worth, and each vault is a hedge counterparty to each other. When the GLP ratio shifts, assets are transferred between the three vaults. When necessary, Umami will also hedge on GMX or similar platforms. The product is expected to be released in mid-2023.
GMD protocol
The main idea of GMD is to split GLP into single coins for sale, which is suitable for users who are averse to impermanent losses to invest in BTC, ETH and USDC in single coins. The GMD platform will collect part of the income as a reserve to absorb the risk of fluctuations in the proportion of GLP assets, and provide compensation when the vault incurs losses. At the same time, the protocol will adjust the proportion once a week, including:
The entry fee is higher for pools with high demand.
APY, which adjusts weekly based on the performance of GLP.
The upper limit of the three funding pools.
The overall strategy is a pseudo-Delta neutral strategy. At the same time, the platform will extract a portion of the GLP revenue as its own platform income to reward token holders.
After users subscribe to the fund pool, they will receive corresponding gmd tokens, such as gmdBTC, to represent their share of the fund pool. The ratio of gmdBTC to WBTC will increase as GLP revenue accumulates, but the ratio is relatively stable. Users can provide liquidity on Uniswap V3 to earn additional income, and can also allow other users to purchase shares in the secondary market through transactions after the fund pool reaches its upper limit.
At present, all three Vaults on the GMD platform have reached their upper limits. Obviously, this product is very attractive to users. The current data is:
Pseudo - delta - neutral protocol $GLP
GLP TVL： 2.67 M
BTC 27 $ 455, 866.62
Current GMD share: 14.98%
Current GLP share: 18.13%
GMX Target Rate： 15%
Current APY: 10%
USDC $ 1, 500, 482.09
Current GMD share: 58.30%
Current GLP share: 39.86%
GMX Target Rate： 39%
Current APY: 9%
ETH 650 $ 980, 470.98
Current GMD share: 26.63%
Current GLP share: 29.12%
GMX Target Rate： 35.00%
Current APY: 11%
Neutral Finance
Neutra Finance, after five months of testing, users invested in stablecoins, and the platform was able to stably achieve an annualized return of about 10%. The core solution adopted by Neutra Finance is off-chain strategy and on-chain operation, using the Tolerance Band - Volatility Model. Part of the USDC invested by users will be converted into GLP to generate income. In addition, part of the funds will be used to open short orders of BTC/ETH on GMX for hedging, using 5.5-6 times leverage.
Unlike other platforms that use fixed-time hedging solutions, Neutra Finance will calculate the volatility of risk asset exposure that accounts for half of GLP. As the name of the strategy "Tolerance Band" indicates, the adjustment of the hedging end will be triggered only when the predicted price volatility calculated based on historical prices and the GLP asset ratio deviation reach a value. The cost of hedging in this way will be lower. According to the current test situation, the product is running well. The strategy will be launched in Q1 2023. Considering the fund operation costs and fees, the overall APR will be slightly lower than 10%.
In addition, Neutra Finance is also studying hedging solutions for Sushiswap and Uniswap LP to provide users with more low-risk financial management options.
Summarize
LP tokens are high-quality on-chain assets, providing liquidity for traders in the web3 trading network and providing fee income for LP investors. Compared with GMX's GLP, which has 317M TVL, among the GLP-based products currently launched, Rage Trade and GMD Protocol only hold 10M and 3M GLP respectively, accounting for only 3% of the total GLP. Most of the GLP is still "naked", and the holders bear risk exposure.
Some of the main reasons are:
The imperfection of on-chain hedging tools.
In the current hedging solution, GMD adopts a split and uses part of the GLP income as a reserve to avoid excessive impermanent losses. In fact, it loses investors' income to balance the risks and achieve "pseudo Delta neutrality".
Rage Trade uses Aave, but the leverage ratio that Aave can achieve is relatively low, which actually sacrifices the efficiency of fund use. In the end, Rage Trade chose to split the overall solution into two high/low risk funding pools.
Other solutions that have not yet been launched consider opening hedging positions directly on GMX. In fact, GMX, as a perpetual contract platform, is not suitable for long-term position holding. The annualized cost of directly holding positions is about 20%, and there will be additional handling fees for opening positions, which brings additional costs to the protocol each time it balances the hedging assets.
If there are more hedging tools on the chain, such as options and other assets suitable for long-term holding, LP-based hedging products will be more abundant.
Considering risk control and liquidity reasons, the amount in each vault was very limited in the early days.
Since the first GLP-based Umami USDC Vault was launched, GLP-based products have only been around for five months, and the USDC Vault was shut down shortly after it was launched. The multiple factors that make up GLP make hedging relatively complex, and various strategies still need sufficient time to run and test before they can be scaled up.
The instability of GMX itself.
GMX is a project that has only been active on Arbitrum for a year, and it still has many risk factors. These include: single-point manipulation of the oracle, where only the project party has the authority to write prices, and the price factor is very centralized compared to other parts of the product; there have also been many improvements to the design of GLP, including improvements to GLP routing, which led to a vault migration of the GMD Protocol.
In addition, GMX itself has a natural threshold due to the use of oracles as price input. PMM LP, similar to GMX/GLP, uses external oracles to introduce prices, which can achieve higher LP utilization efficiency, but in reality, "second-hand prices" cannot achieve price discovery. Even due to the lag of the price feed of this mechanism, the largest trading pair of Dodo, which uses the same PMM mechanism, on Ethereum is the stablecoin trading pair.
The innovative design of GMX allows GLP to have sufficient capital utilization efficiency while setting target ratios and arbitrage mechanisms, making the LP structure simple and easy to hedge. However, it also has flaws: it cannot achieve price discovery and the execution price is poor (the "second-hand" price provided by the Chainlink oracle), which also sets a ceiling for its future transaction scale.
In addition, on-chain transactions are prone to traders and network nodes connecting to obtain information in advance to achieve unfair information arbitrage. As a passive liquidity provider, LP provides benefits to traders with information advantages. This is also the toxic flow mentioned by many DeFi researchers. In the long run, it will reduce the credit level of the market. Whether it is AMM or traditional financial exchanges, traders (Takers) have more information advantages than liquidity providers (Makers). Every transaction is made because of the information obtained and the prediction of the future. In the AMM mechanism, this is more prominent because LP is lazy liquidity.
But overall, LP is still the original high-quality asset on the chain at present, and is the most likely to drive the demand for on-chain derivatives and build a stable income product that is more recognized by the mass market. At present, GMX's GLP has derived an ecosystem based on LP financial derivatives on the chain faster than LPs of other AMM DEXs such as Uniswap due to its relative stability. In addition to the problems of GMX itself that need to be solved, how to better achieve on-chain hedging requires more derivatives/short-selling tools and products and attempts. The solution to the problem is not technology, but a complete set of solutions. iZUMi is also actively exploring LP financial derivatives and looks forward to more attempts at on-chain financial products.