Liquidity Pool Hedging
Last updated
Last updated
Liquidity Pool Hedging is a delta-neutral strategy that Arcana plans to implement after the protocol's launch. This strategy is not active from day one but is part of the near-term roadmap to expand arcUSD yield capabilities.
The Liquidity Pool Hedging strategy builds on the principles of the cash and carry trade, enhancing the approach with a more capital efficient use of assets. Unlike traditional cash and carry where assets are solely used as margin to maintain a short position, this strategy involves deploying a portion of the assets into DeFi liquidity pools from established, battle-tested protocols to earn yield from trading fees and LP rewards. Another portion is utilized to short the assets in these pools, achieving a delta-neutral position. Arcana is actively exploring liquidity pool opportunities in DeFi for highly capitalized tokens like ETH, SOL, and similar risk-grade tokens, aiming to maximize yield while managing exposure risks.
This strategy plays an important role in supporting the overall health of the Arcana protocol and the stability of arcUSD. By providing an alternative source of yield, this strategy is particularly useful during periods when the Bitcoin cash and carry trade is not profitable due to negative funding rates.
Recognizing that Liquidity Pool Hedging comes with additional risks associated with DeFi protocols, such as impermanent loss and smart contract risk, Arcana strategically limits this strategy to a smaller portion of the overall protocol portfolio.
Here, we delve into the operational details of how Arcana implements this strategy:
Asset Allocation: Arcana strategically divides the assets into two main portions. The first is allocated to selected DeFi liquidity pools from established and battle-tested protocols.
Yield Generation: By participating in these liquidity pools, Arcana capitalizes on yields generated from LP fees and rewards.
Hedging Position: Simultaneously, Arcana uses the second portion of the assets to open a short position against the same assets placed in the liquidity pools. This setup aims to maintain a balanced, delta-neutral position that mitigates potential losses due to price volatility in the underlying assets.
Position Rebalancement: Given the nature of liquidity pools and the presence of impermanent loss, the asset ratios in the pools can shift as market conditions change. Arcana routinely rebalances the positions to align with the original investment strategy and minimize risk exposure from these shifts.
The chart below presents an insightful look at the performance of a test conducted using the Liquidity Pool Hedging strategy.
Deposited, Hedged TVL (Black Line): The hedged TVL remains relatively stable throughout the observed period, showcasing the efficacy of the hedging strategy in preserving capital amidst significant price fluctuations in the underlying assets. Despite a substantial rally of ~85% and a subsequent retracement of ~25% in the underlying asset, the strategy effectively mitigates the potential losses, primarily due to impermanent loss. However, any impact from impermanent loss is substantially offset by earnings from liquidity pool fees and rewards.
TVL + LP fees & rewards (Gold Line): The TVL that includes fees and rewards collected from DeFi liquidity pools shows a significant upward trend, indicating a successful accrual of additional yields on top of the hedged capital. The growth trajectory highlights the powerful combination of hedging with active participation in yield-generating DeFi protocols.
Performance metrics: Over the test period, the Liquidity Pool Hedging strategy achieved an Annual Percentage Rate (APR) of ~35%. When these returns are compounded, the Annual Percentage Yield (APY) grows to over 40%.
