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Why does Uniswap V3 significantly increase the market-making risk of LP?

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Uniswap V3 increases the efficiency of market making funds while also greatly increasing the volatility losses that LPs may suffer. This paper analyzes in detail the impact of different strategies on investors' ending returns and emphasizes that reasonabl

In the early days of Uniswap V3's launch, many of the earliest LPs to join the market for V3 enjoyed extremely high fee yields. But the good times did not last long. The entire crypto market suffered a sharp drop in price in late May, and many V3 LPs found that not only had their entire trading position changed to the one with the lower price in the pair, but the loss of their entire position in the market volatility had increased significantly compared with V2.

So, how has the risk of Uniswap V3 LP changed compared to V2, and how should investors better understand this risk? This article hopes to analyze the changes that Uniswap V3 will bring to investors from the most basic principles of market making.

From a liquidity provider to a portfolio manager

How to treat the "provision of liquidity" objectively is a critical issue. Being a Liquidity Provider (LP) of Uniswap allows you to gain transaction fee income, but at the same time, you have to bear the risk of changes in the ratio and price of different currencies. Therefore, relying solely on yield as the sole indicator for investment decisions clearly has serious drawbacks.

So how can we more fully assess the pros and cons of providing liquidity? Here, we suggest that participants switch to a new perspective to think about the whole problem. That is,Think of the provision of liquidity as a portfolio management strategy adopted by investors.

This strategy, on the one hand, does not need to rely on the subjective judgment of fund managers for artificial operation, and on the other hand, it dynamically adjusts the proportion of investors' positions according to market price changes and fixed algorithms.We have renamed this new portfolio management strategy, which combines the essence of passively managed funds without human intervention and the mechanism of proactive position shifting.Active passive asset management strategies".

From this perspective,Instead of being seen as liquidity providers on trading platforms, former LPs will be seen as investors who want to preserve and increase their assets. Therefore, the criterion for evaluating whether it should become LP will also change from a single market-making rate of return to the expected return of the investment portfolio and the risk that may be assumed in the investment process.

So what are the main risks of being an investor in such an "active passive asset management" fund?

Impermanent loss and inventory risk

Choosing a reasonable performance evaluation benchmark is the most critical premise to evaluate the risk return of a portfolio.When we evaluate the risk return of a credit bond, we can choose the interest rate of national debt without credit risk as the evaluation benchmark. Evaluate an actively managed equity investment fund by selecting a composite index of the overall stock market at the same time. In general,The benchmark you choose to use to evaluate investment performance depends largely on the other best options available to the investor without participating in the investment, which is often referred to as the opportunity cost.

Then, when evaluating this "fund" named LP Position, which index should investors choose as the evaluation benchmark?

Take the ETH-USDC trading pair as an example. For bullish ETH investors, full holding ETH can be his benchmark; For a bearish ETH investor, holding all dollars is the benchmark; For investors who do not expect the ETH price to fluctuate significantly, they can take the evaluation benchmark by keeping the status quo and not participating in market making.

As a result, we constructed the following four different investment strategies (each with an initial total of $1,000) :

1.100% hold the ETH

2.100% hold USDC

3.50% ETH and 50% USDC

4. Use 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, excluding fees, and the horizontal axis shows the possible different ETH prices at the end of the period. We can make a functional picture of the performance of the end market value of the above four portfolios at different end ETH prices.

As you can see, if the ending price of ETH does not change relative to the beginning price ($3000), then the ending market value of the four strategies will also remain the same ($1000). However, if the ETH price drops, then Strategy 2 (holding USD) is the best choice. If the price of ETH goes up, Strategy 1 (holding ETH) is the best option.

And one of the things that's remarkable about this is that,If the investor chooses Strategy 4 (green line), in which he participates in market making by buying a fund called LP Position for $1000, the ending market value of the fund will always be lower than Strategy 3 (yellow line), except for the starting point of the price. And this part of the difference, is often referred to as "variable loss".The fickle losses reflect the additional losses that investors are expected to incur as the fund, known as LP Position, actively adjusts positions when prices change.

Let's go back to the perspective of the investor. Assuming that Investor A expects the price of ETH to rise in the future, then if Investor A buys an "LP Position" fund at the beginning of the period, what risks will Investor A take if the price of ETH actually rises?

Since Investor A has purchased the "LP Position" fund, he will bear the risk of unpredictable losses caused by the fund when the price rises, i.e., the difference between Strategy 3 and Strategy 4. At the same time, since the optimal strategy is to hold the whole Position of ETH, the 50% of USDC converted for buying the "LP Position" fund will not be able to enjoy the profits brought by the subsequent rise of ETH. Therefore, this part of the Position will bring the "inventory risk" loss to investor A, that is, the difference between Strategy 1 and Strategy 3.

Therefore, for investor A, the inventory risk brought to him by buying the "LP Position" fund for market making will be far greater than the risk of unpredictable loss. From this, we can draw the following conclusions:

1. For investors who expect ETH prices to rise, purchasing an "LP Position" fund will entail significant inventory risk. Therefore, the optimal strategy would be to stay away from market making activities and look for other ETH based investment vehicles (such as participating in the POS Pledge for Ethereum 2.0).

2. Similarly, investors who expect the price of ETH to fall should stay away from market making activities, so as not to passively hold ETH and thus bear the inventory risk of its price falling. The optimal strategy would be to look for stable-based wealth management or mining activities.

3. For investors who expect ETH prices to remain stable, it makes little difference whether they own ETH or USDC (because they expect prices to fluctuate very little between the two). So using two currencies to buy some kind of "wealth management product" to earn income can be a good choice.

But as we just mentioned, the net return from buying such a fund, called "LP Position," relative to not buying it is negative (the end of Strategy 4 is always less than Strategy 3). So why do investors become LP's to help the trading platform make markets?

A commission is a compensation for a variable loss

In order to simplify the model above, we ignored the effect of commission fees on the ending market value. Now let's refactor in the impact of fees and see how different strategies in real life would change an investor's ending market value.

We find that when fees are taken back into account, it makes sense to buy "LP Position" funds to participate in market making. With fee income as compensation, strategy 4 (green line) finally has a higher ending market value than strategy 3 (yellow line) within a given price range. Therefore, the logic for investors to buy "LP Position" funds to participate in market-making activities is also clear:In order to obtain positive returns within a certain ending price range, investors have to bear the risk of loss if the ending price fluctuation exceeds this range.

In other words, participation in market making activities can achieve positive returns on the premise that investors do not expect asset prices to fluctuate significantly at the end of the period. Once the ending price of the asset exceeds the safe range, the investor's portfolio will bear the corresponding risk of loss. That's why some people call it liquidity market making, what's called"Short Volatility"The reason why.

Uniswap V3 is the risk amplifier

In the above discussion, we have been using the classic Uniswap V2 model as the reference criterion for evaluating market making activities. However, we know that in the latest version of V3, Uniswap is spending its money more efficiently, and the shape of its final yield curve will definitely be different from the previous version of V2. Now let's update the previous graph of the end of term earnings and introduceStrategy 5, that is, the ending return of the "LP Position Fund" provided by the V3 version of UNISWAP with the same funds.

It's very clear from the graph above that compared to the previous graphStrategy 4(Uniswap V2),Strategy 5(Uniswap V3) not only greatly improves the return level of investors when the price is stable, but also greatly increases the loss degree of investors when the ending price exceeds the safe range. Say so,Uniswap V3 is both an amplifier of investor returns and an amplifier of risk. Investors in the V3 version of "LP Position Fund", while enjoying higher investment returns, are bound to bear more volatile losses when the ending price deviates from the safe range.

High returns inevitably bring high risks, which is an immutable law in finance. Even in the world of blockchain, it still hasn't changed a bit.

Shorting volatility is the most dangerous investment strategy in the crypto industry

Through the discussion above, we have clearly understood thatThe basic assumption that a liquidity provider (LP) can make a profit is that it participates in a market-making transaction and that no significant price changes will occur over the expected investment period.If this premise is disproved during the investment period, the ending market value of the investor will tend to be lower than the ending market value of the investor who did not participate in the market making and kept the original portfolio.

This default assumption of low volatility is ubiquitous in the cryptocurrency investment industry today. For example, we can often see the annual rate of return of mining activities of some projects is more than 1000%. Behind these extreme rates of return, in fact, there is often an implicit assumption that the price of the relevant tokens will never change.

Many investors, after participating in some so-called "high yield" activities, often feel that their final returns are not as good as the initial expectations, and even have a loss.The fundamental reason is often not the calculation process of the project side's rate of return is wrong, but the "premise assumption" for low volatility is incorrect.

The crypto industry is still a very new investment field, and the price volatility of various products is extremely high, so any assumption of low volatility can be costly for investors. I'm not here to discuss the flaws of the Uniswap V3 model, but rather I thinkUniswap V3 is an important innovation in the industry because it gives investors the power to take higher risks and reap higher returns. Putting the ultimate option of risk-taking back to the market is the most important innovation in the underlying logic of Uniswap V3.

But for the average user participating in V3's market-making activity, it's important to understand that this is just a trade-off between risk and benefit. Do not simply see the rate of return of others, do not understand its inherent risk logic on the premise of blind entry, and ultimately bear their own can not bear the unpredictable loss.