As we discussed last week, in the traditional financial world, ETFs and index products are the most widely traded instruments, and companies such as BlackRock ($7.4T AUM) & Vanguard ($6.2T AUM) are the largest asset managers in the world with trillions of assets under management. In light of this, new permissionless DeFi indexes present a huge opportunity for growth with newcomers and crypto veterans.
Recently, one of the partners of ParaFi Capital Santiago Santos tweeted out a great idea below about how to use automatic pool rebalancing as a strategy, and I’d like to walk you through how being an LP in a pool that uses an index + ETH allows one to deploy a strategy taking advantage of impermanent loss. That’s a mouthful but I’ll explain more below and I promise the tutorial is super easy with as little as 3 transactions all from your Zapper dashboard.
DeFi Pulse Index
First, the DeFi Pulse Index (DPI) recently launched on TokenSets. It is a capitalization-weighted index that tracks the performance of decentralized financial assets across the market. The index allows one to gain exposure to the following “blue chip” DeFi tokens: LEND (soon to be AAVE), SNX, MKR, UNI, YFI, COMP, REN, LRC, KNC, BAL, and REP.
With this index, you have 1 of 2 ingredients necessary for automatic pool rebalancing as a strategy.
How Impermanent Loss Works
The second ingredient most do not understand. When you provide liquidity to Uniswap (or any other automated market maker), you provide a 50/50 provision of tokens. In Uniswap, the pool is always 50/50 but in other new AMMs like Balancer, the ratio of tokens can be changed. When you are a market-maker in a pool (aka an LP), you are taking the opposite trade of the market. For example, if the market is going up for ETH/USDC, then you are selling ETH to buyers for USDC. When the market is bearish and going down for ETH, you’re buying ETH while traders sell you ETH in exchange for your pooled USDC.
This is referred to as “impermanent loss.” Impermanent meaning if the price goes up or down from when you entered, your 50/50 provision of liquidity could be become more weighted to either token, but if the price returns to where you first entered, you get back to your original 50/50 provision, plus some % of the 0.3% trading fees being paid by Uniswap traders.
The key takeaway is that if the market prices are very volatile, you’re more prone to impermanent loss. Normally volatile prices also come with high trading volume, which can earn trading fees for LPs butit also can drive greater buying or selling pressure, moving market prices further, which leads to even more impermanent loss.
But what happens when you turn impermanent loss into an intentional strategy?
How to Use Automatic Pool Rebalancing as an LP Strategy
It’s not rocket science to observe that most of the crypto markets are correlated–they move up and down together in price. When we look at a pairing in Uniswap like the DPI-ETH pool, we’re observing 2 tokens, likely but not guaranteed to move together in lockstep.
In the DPI-ETH 50/50 Uniswap pool, there’s about $24M in liquidity and about $1M in trading volume the last 24 hours.
If the goal of an LP is to sell out of the fastest moving rocket ship in the market (eg. if DPI/USD is moving upwards in price faster than ETH/USD), then…
Hi! My name is Lark Davis!
I’m a cryptocurrency investor with years of experience and I’ve been making consistent profits in the crypto space.
I’m passionate about helping others do the same, so I run multiple educational channels on crypto investing.
