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Why don't you make money in DeFi market making? 5 Misunderstandings of Being an LP in Uniswap V3

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Only when we have a better understanding of financial markets, protocol principles, and market-making auxiliary protocols, can we control the role of market makers and achieve stable and profitable liquidity providers.

Original title: "Why don't you make money in DeFi market making? 5 Misunderstandings of being an LP in Uniswap V3! "

Original author: Jade

In Uniswap v3, the capital efficiency of providing liquidity is higher than that of v2 up 600 times. However, studies have shown that more than 80% of people have not obtained stable profits for a long time because of AMM's LP, and their performance is far worse than that of the Buy and Hold strategy. The following are the five common misunderstandings we sorted out:

1. Do not understand LP rules and who the winner is

2. Don’t understand the LP yield curve and principle

3. Don’t understand how to choose the right asset pair

4. Don’t understand how to choose the commission rate and entry timing

5. Do not understand that it is wrong to change the range too frequently

The above order is the key to learning to be an LP winner, we Will summarize in order:

Misunderstanding 1: Do not understand the rules of LP and who the winner is

AMM’s LP has only one iron rate to become a winner:

LP fee—Impermanent loss (free loss), IL > 0

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This iron rate tells us that there are two ways to become an LP winner, increase LP fee or reduce Impermanent loss, IL

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Increasing LP depends on using the right asset pool to create a market in the right range, that is, what kind of market to create?

Lowering IL depends on your view on the trend of the asset, that is, when to make the market?

First of all, you must understand that in order to improve v2’s LP revenue efficiency, v3 converts v2’s evenly distributed liquidity into peak and long-term Tail liquidity allocation. Just like TradFi’s order book, only the upper and lower levels close to the market price have the best liquidity. LP must make the most efficient acquisition of concentrated liquidity under the assumption that the price of the asset pair will consolidate or not fall. And delta hedge when necessary to reduce the risk of IL.

< p>In general, it is extremely important to let you know "how" and "when" to open an LP range from the perspective of a TradFi market maker. Generally, retail investors do not have enough capabilities and tools, resulting in the concentration of LP income in the pockets of top players. Learning knowledge and making good use of various income liquidity managers is the only way you can catch up with them.

Misunderstanding 2: Do not understand the essence of LP yield curve

From the perspective of U-based Looking at the profit and loss curve of v3, this curve is essentially the Sell Put in Options. To be more precise, this is a kind of Sell Put that has no time value, but can earn profits because of the continuous increase in fee income.

According to the characteristics of Sell Put , the opening range of LP should only be set when the price is not expected to fall or consolidate. Therefore, the effect of opening a position in a bear market or a bull market is not ideal.

Next, when the price of a certain currency in the LP trading pair rises beyond the set range, the constant product curve of AMM It will automatically adjust to reduce the position of the dominant currency, and eventually all LPs will be replaced with less valuable currencies. Therefore, make sure that both currencies of the provided liquidity pool are valuable, such as BTC-ETH-USDC.

Misunderstanding 3: I don’t understand how to choose the right asset pair

Many people do LP and are undervalued The high APR of the liquidity pool is attractive, but to become a long-term LP winner, you need to avoid choosing a small liquidity pool with a high APR, otherwise you will lack the continuity of income, and stable income is the truth of LP.

We must ensure that the asset pair:

There is sufficient trading volume

Sufficient Liquidity

Refer to the 24H fee in the pool And TVL is very important, Guillaume Lambert suggested that the 24H fee is at least greater than 1K US dollars and the asset pair pool with TVL greater than 1M US dollars is very safe. Unless you want to arbitrage or create a market for a newly issued potential currency (such as ABR a while ago), choosing the right trading pair is very important.

< h3>Misunderstanding 4: I don’t understand how to choose the fee rate and the timing of entering the market

How to choose the right rate level? The volatility of the asset pair determines which rate level to choose. The more stable the pool, the lower the rate will be selected, and the less stable the pool will be. According to the discussion of myth 1, please make the market by staying with the winners in the most liquid pool. For example, the liquidity pool associated with stablecoins, the 0.05% service fee pool absorbs more than 90% of the liquidity, and its DEX price is the closest to CEX, which helps reduce transaction friction costs and attract more users.

How to choose the right entry time? According to the discussion in point 2, the handling fee earned by LP can be evaluated as an increasing perpetual time value, so as to understand how to enter the market at the right time. The best time for options sellers in TradFi is when the volatility is high and the seller is not easy to cause unlimited losses because of the reduced directional risk, but also because the highest volatility represents a fat option premium, and the seller can collect it as soon as he enters the market The premium caused by "panic".

Back to the flow pool, assuming you have previously screened out a high-quality flow pool, when the volatility of the currency price is high, although it means There is a greater chance that the price will break through the market-making period, but at the same time, it implies that there are enough traders in the trading pool, which can bring LP a lot of transaction fees in a short time. Of course, it is very dangerous to enter the market when the volatility is about to increase. You must carefully evaluate whether the end of the party is coming, and that will be the best time to enter the market for LP!

Myth 5: Not understanding that it is wrong to change intervals too frequently

Currently many current The performance manager tried to keep track of V3's LP market-making range, and actively moved the range to achieve rebalancing, which achieved very poor results. We use a backtest report from JPN to share this point of view.

The summary of this backtest is as follows. The standard deviation is a strategy of continuously moving the market-making interval, and the parameter is the standard deviation of the exchange rate in the moving interval. The backtest shows that the higher the frequency of mobile city-building intervals, the less the fees obtained can exceed IL. Of course, as Layer 2 matures and reduces gas fees, maybe the red line of this report will not lose so badly, but the general direction indicates that frequent adjustments to the city-building interval are wrong decisions.

From Misunderstanding 4, you should understand that the timing of market making is often the best time to enter the market for consolidation, and the empirical evidence of the financial market shows that the trend It doesn’t happen very often. If you often adjust the market-making range of LP, it is equivalent to constantly chasing infrequent events, which runs counter to LP’s idea of stable income. The best way is to use spot hedging to avoid the lower risk or the upper IL when the trend comes out.

< p>Uniswap V3's Automated Market Maker (AMM) is undoubtedly a gift that DeFi brings to the financial market, allowing everyone to participate in the market-making business without having to face the high barriers set up by TradFi and CeFi, allowing everyone to Become any role in financial activities.

Only when we have a better understanding of financial markets, protocol principles, and market-making auxiliary protocols, can we control market makers The role of a liquidity provider that achieves stable profitability.