Talking about the principle of Uniswap's fund pool, and how the CPPI strategy can be integrated into DeFi
Original title: "Talking about constant mixed strategy and Uniswap, how CPPI strategy can be integrated into DeFi"
Original source: Pakistan Bit
Note: The original author is Kevin Sekniqi, Ph.D., Cornell University. In this article, he uses the constant-mix strategy to explain Uniswap’s asset pooling principle and proposes that such a strategy is profitable in a volatile and mean-reverting market. In addition, he mentioned the Constant Proportion Portfolio Insurance (CPPI) strategy, which outperforms the Constant Mix strategy (i.e. Uniswap) in differentiated (depreciating or appreciating) markets, while the combination of the two strategies may It will become a trend of DeFi in the future.
An interesting tweet (can't seem to find it now) popped up in the crypto twitter space recently discussing Uniswap and impermanence Constant-mix strategies in the context of losses, a well-known and simplistic dynamic portfolio management technique.
It surprises me that people don't seem to be aware of the constant mix strategy. In fact, constant mixing strategies have been known and used since 1985, and possibly much earlier. Yes, you are not mistaken! Since then, Perold et al have written a great journal on this topic. In fact, part of this article is derived from those papers.
Here, I want to take a moment to discuss portfolio management strategies through Uniswap. The interesting thing about Uniswap is that it's not an exchange, and people don't seem to realize that! Well, at least, the exchange side is a second order effect. In fact, it is a smart contract that implements a specific type of dynamic portfolio management strategy, the so-called constant-mix, which can be simply explained as "buy when it goes down, sell when it goes up". This in turn has a concave payout structure. We'll discuss all of these shortly.
However, if someone insists that Uniswap is an exchange, then he is technically right as soon as possible, but in fact Uniswap is only through second order effects. The exchange presented. That's like saying mayonnaise can be food. Yes, food is indeed a secondary role for mayonnaise, but its main purpose is as a condiment.
And what I want to achieve in this article is to explain everything in the simplest language so that even a layman can understand it. Many people in this industry tend to rename basic things that have been known for decades, including impermanent loss (IL), automated market maker (AMM), etc., and we will keep it all simple.
Background
First of all, in this article For the rest, I will ask you to forget about "impermanent loss", "automated market maker" or other terms associated with Uniswap. It's all a renaming of something that already exists, and it's confusing.
We will try to learn these things with proper terminology so that you can easily and independently read the relevant literature in finance without having to rely on bad Encryption blog posts...like this one.
Now, let's get started. To understand why Uniswap does what it does, let's first state our goal: we want to understand Alice, a savvy investor, how she allocates assets between stocks and cash in a way that best suits her risk profile. Of course, the market maker behavior will inform her risk profile to some extent.
For simplicity, Alice can only hold assets in cash or by buying stocks. In other words, Alice needs to decide how to "balance" and "rebalance" her portfolio between these two assets. This looks like a pool of assets in Uniswap, and we enforce this simplified restriction because we can infer the total value of Alice's assets through a one-dimensional variable (i.e. stock value). Cash remains constant, and if we want to use two assets, say stocks and bonds, we need to visualize the 3D surface. That's not too bad, but to make it easier for us to understand, you only need to consider one input variable x (stock value) and its relationship to y (total portfolio value in USD). All analyzes here can be easily extended to any number of variables.
If Alice was very risk-averse, she would choose all cash. If she's more adventurous, she'll go for stocks. Note, however, that I did not ask a few questions, including "Which stocks should Alice buy?" This is a question that has nothing to do with portfolio management. Instead, what matters most to Alice is "when should she buy or sell the stock" and "how much".
And in the rest of this article, we will discuss three strategies:
Buy And hold strategy: do nothing;
Constant mixed strategy: buy when falling, sell when rising;
Constant Proportion Portfolio Insurance (CPPI) Strategy: Sell when the stock price falls and buy when it rises;
Between the three An interesting point is that they will have different returns depending on how the market behaves over time. The first strategy is linear, which means it depends only on current market conditions (i.e. how well the stock is doing), while the latter two will have a bump-and-convex way, meaning that if there is a mean inversion (i.e. concave maximum in the middle), the second will do well, and the third will do well if there is mean deviation (i.e., the maximum is a stock that rises or falls sharply). We will describe all of these in detail later.
Portfolio Strategy #1: Buy and Hold, i.e. Do Nothing
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Doing nothing, or what is commonly referred to as a "buy and hold" strategy, is very well understood. Alice will choose a certain cash/stock allocation at the beginning, and let it be. The better the stock, the better the portfolio outcome, as shown in the chart above. Clearly, net payout is a linear function whose slope depends on the original allocation between stocks and cash. The more stock, the higher the slope, as shown below.
When Alice is fully in cash, her net portfolio performance is independent of stock performance. The slope is zero at this point, which is straightforward.
Portfolio Strategy #2: Constant Mixed Strategy, or Buying Down, Selling Up
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This is where strategy becomes more interesting. As the name implies, these strategies aim to maintain a constant exposure to stocks in proportion to the stock portfolio. This is exactly how Uniswap works, after creating a new asset pool, the protocol aims to keep the ratio between two assets y and x constant (i.e. x*y=k, where k is some constant).
Conceptually, a constant mix strategy aims to increase exposure to an asset as its value declines. This is a classic example of stock-to-bills. Suppose Alice invests $60 in stocks and $40 in cash, creating a constant 60/40 mixed pool. Then suppose the stock falls by 10%, so the value of the stock falls from $60 to $54 and the value of the portfolio falls from $100 to $94. At this point, the ratio would be $54/$94, or 57.4%, below the forecast of 60%. At this point, the agreement stipulates that Alice must buy more stock (because she needs to buy depreciating assets), thereby increasing her stock exposure to the 60% level. Alice will need to take $2.40 out of her cash position to buy the stock, bringing the stock position to $56.40 and reducing the cash position to $37.60. Now, the new percentage is 60/40 again (ie 56.4/94=60; 37.6/94=40). Let me reiterate: this works the same as a Uniswap asset pool, with the caveat that anyone can deposit funds into a specific token pool, not just Alice. Of course, what Uniswap involves is no longer stocks and cash, but tokens, such as AVAX and ETH.
Now, let's get one thing straight: this is a weird concept. Why would the smart investor Alice buy more assets that depreciate. The answer, of course, is not because Alice doesn't know. Rather, it is because Alice believes that the market in which she is implementing this strategy is volatile and mean-reverting. Of course, if this is the case, then it would make sense for Alice to keep buying more of the depreciating asset, since it will quickly return to a higher value, and in this case it doesn't matter how much the asset falls, you just keep going buy.
"The constant mix strategy (i.e. Uniswap) is profitable in a volatile but mean-reverting market." Since Uniswap is just a constant mix market, This means that as long as the target pool contains only mean-reverting markets, it is always profitable to be a liquidity provider. On the other hand, if you provide liquidity to the market, and these markets vary greatly (ie, permanent depreciation or permanent appreciation), then your profitability as an LP joining Uniswap is more profitable than simply buying and holding The strategy is much lower. Or, as we will see shortly, the CPPI strategy. The chart below shows the constant mix strategy compared to the buy and hold strategy.
This effect is also shown more precisely in the image below. As one can see, if you just buy and hold as the market diverges, the long-term profitability of a constant mix strategy is very low. Why? Scenario 1: If the value of the stock market falls sharply (and stays at that level), then continued mixing will buy more and more worthless assets. Scenario 2: If the value of the stock market rises sharply (and stays at that level), constant mixing sells more and more stocks instead of other relatively depreciating assets (cash in this case).
So, all in all, if the assets return to the usual average, it will be worthwhile to become an LP of Uniswap. Otherwise, this is absolutely costly and it should not be the strategy Alice employs.
Portfolio Strategy 3: Constant Proportion Portfolio Insurance (CPPI), or sell stocks when they fall and buy when they rise
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What happens if the market doesn't revert to the mean? Conversely, what happens if the market deviates significantly from the entry point, that is, the underlying depreciates or appreciates significantly? Of course, implementing a constant mixing strategy (i.e. becoming a Uniswap LP) is not optimal for Alice, as mentioned above. Instead, Alice should sell the asset when it depreciates in value, and then buy the appreciating asset. This makes sense: if Alice knows the stock will continue to depreciate in value, she should sell as much of it as possible, and if she knows the stock will continue to appreciate in value, she should buy as much as possible. This type of strategy, known as a Constant Proportion Portfolio Insurance (CPPI) strategy, takes the form: Dollars in Equities = m(Assets - Floor), where m is a fixed multiplier which is Alice Part of risk tolerance. As shown above, these strategies perform well when markets diverge rather than regress, making them convex.
Here is how Constant Proportion Portfolio Insurance (CPPI) works: Suppose Alice chooses m=2, floor is $75 (the latter floor is Alice’s The lower limit tolerance for losses caused by equity depreciation). Based on these numbers, Alice's stock is worth = 2*($100 - $75) = $50, so Alice splits the stock and cash 50/50. The following image shows a graph of this venture portfolio:
Given Alice chooses m=2 with a floor of $75, here is how her portfolio would perform during a downturn. Assuming a 10% drop in the stock, her stock depreciates from $50 to $45 and her total portfolio depreciates from $100 to $95. Since the CPPI rule forces the stock position to become 2∗($95−$75)=$40, Alice must sell an additional $5 worth of stock and further reduce her exposure. In other words, a 10% drop in the stock forces Alice to sell $5 worth of stock. Now, her risk assets have become "light".
"Constant Proportion Portfolio Insurance (CPPI) Outperforms Constant Mixed Strategies (i.e. Uniswap) in Differentiated (Depreciating or Appreciating) Markets." CPPI Implement stock options in a roundabout way without using standard option techniques. Alice's losses are capped at $25 (since the floor is $75), while she enjoys a high (though not unlimited) upside. In summary, in a bear market, the CPPI strategy will protect Alice, and in a bull market, the CPPI strategy will outperform. However, if there are frequent reversals, it will perform under a constant mix strategy (i.e. Uniswap). The chart below shows the CPPI strategy compared to two different buy and hold strategies.
Final Thoughts
Uniswap is an interesting experiment. It is the first successful deployment of constant mix smart contract based portfolio management between any two pairs of ERC-20 tokens on Ethereum. Its second-order effect is as an exchange, although it's safe to say that exchanging assets via this method is far inferior to a standard order book-based exchange. Please don't @ me on twitter, I have read the arguments about AMM and they are in fact wrong. There is a reason why AMMs are not used in all mainstream financial markets.
In any case, it will be interesting to see some on-chain protocols that offer CPPI policies. It will then be very interesting to see how they work with protocols for constant mixed strategies. I would expect traders to frequently resize positions into Uniswap and CPPISwap depending on market conditions. However, it's clear that it's too early for us to talk about this and there's a lot of stuff that has yet to be implemented.
Related information: Perold, Andre and Sharpe, William. Dynamic Strategies for Asset Allocation. Accessed 2020.
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