🚀 Volmex Finance Deep Dive

Danner.eth on tokenized volatility, impermanent loss, and the newly released Volmex Finance

June 18th, 2021 | Sign up

Happy Friday 😎 Today we’re excited to bring you a special guest post from Zoomer Money community member danner.eth, who takes us on a deep dive into tokenized volatility protocol Volmex Finance.

P.S. This one is a bit on the technical side—so if you are confused about anything—join our discord server and we’ll answer your questions!

Note: Volmex is Finance is currently not available in the US or UK.

A Lesson on Providing Liquidity and Impermanent Loss 💧

Liquidity is an important concept within markets. Asset holders want to be able to exit positions and need buyers to do so. Prospective asset holders need sellers in order to acquire assets. Automated markets makers (AMMs) like Uniswap allow asset holders to provide liquidity to a market in the form of liquidity pools. Liquidity providers are incentivized through trade fees.

An Example 🍎

Let’s assume that an apple is worth $1. You have $10 and 10 apples, worth a total of $20. You are aware that people want to buy apples, and you are willing to sell your apples. Both sides of the trade are worth $1, so who really cares right?

You take your apples and your dollars to the market where you find a pile of 90 Apples and $90. You add your assets to these piles and get a note that represents your 10% share of the pool. When sellers and buyers of apples trade using the pool of apples and dollars, the pool takes a haircut from the trader in the form of a fee. You are entitled to 10% of the fee revenue generated.

Okay — we have a silly liquidity pool of apples and dollars. It’s important to note that to provide liquidity you must supply both sides of the trade in equal value. This allows traders to buy from or sell to the pool. You are paid for facilitating the trade — 0.3% is the standard fee.

Now what happens if there is a worldwide apple shortage? The value of one apple goes up.

Let’s assume that one trader knows about the impending shortage of apples and visits the market to buy all of the apples in the pool for $100. The pool now holds $200. Your note entitles you to 10% of the pool or $20.

Once the apple shortage hits and the value of one apple shoots up to $5, you have experienced what is called impermanent loss. If you had never provided liquidity and kept your initial assets: 10 apples and $10, your assets would now be worth $60 = (10 apples * $5) + $10. Instead, you provided liquidity to a pool that has been cleaned out of apples. Oh well, hopefully you made good fee revenue. Assuming only one trade happened inside the pool (and ignoring the way that AMMs re-price assets depending on the balance of assets) you are entitled to 10% of 0.3% of $90 = 27 cents. Yikes.

Not great 🤧

Again, this is grossly oversimplified and I suggest diving into the below links as well as doing your own research to better understand the roles that Automated Market Makers play and the risk of impermanent loss that comes with providing liquidity.

More on Liquidity Pools by Finematics

More on Impermanent Loss by Finematics

Finematics has a great catalog of videos and articles breaking down DeFi concepts. I cannot recommend their content highly enough.

Uniswap V3 🦄

With the release of V3 by Uniswap, liquidity providers can provide liquidity within target ranges. This is presented as more efficient use of capital, but I see another potential use case to address risks around impermanent loss.

Don’t Sell Your Liquidity Position on OpenSea 🌊

In our previous apples and dollars example, our notes represent a fungible claim to a share of the pool. Assuming a 10% share of the pool, it does not matter which 10% of the pool your note gives you claim to. For this reason, liquidity provider tokens have historically been represented by ERC20 tokens.

In Uniswap V3, positions are unique and a unique ERC721 (NFT) is created to represent the position in the pool. We’ve seen a couple cases where it appears someone thought they got a cool NFT for participating in V3 and thought that they could sell the NFT without any impact to their liquidity position. Oof

About Volmex 🧪

Volmex Labs has recently launched volmex.finance v1 allowing users to mint tokens that track the implied volatility of Bitcoin and/or Ethereum and the inverse of the implied volatility.

➡️ Learn more about Uniswap V3 with the official documentation

➡️ Learn more about volmex.finance v1 on their official blog

Tokenized Volatility by Volmex Labs 👀

When using volmex.finance, a user mints two volatility tokens using stablecoins. In this example, we’ll use Ethereum.

A user would deposit 250 DAI to receive 1 ETHV and 1 iETHV. ETHV tracks the volatility of Ethereum and iETHV tracks the inverse volatility. These tokens always combine to be equal to 250 DAI, but as the volatility increases or decreases, the share of the 250 DAI that each is worth fluctuates.

If Ethereum is in a volatile phase, then ETHV will be worth more than half of the 250 DAI. ETHV and iETHV can be redeemed in equal amount for the underlying DAI value (1 and 1 for 250, 0.5 and 0.5 for 125, etc).

In volmex.finance v1, these tokens must be redeemed in equal amounts.

A Match Made in Heaven 👼🏼

Range bounded assets in liquidity pools turns impermanent loss into a tool 🛠

As single sided liquidity position provisioning opens an entirely new set of opportunities, so do range bound assets in the context of impermanent loss.

When you subject yourself to the risk of impermanent loss in a traditional liquidity pool with unbounded assets, your loss potential is infinite. It’s like shorting an asset vs. buying it spot. If you buy spot, your risk of loss is range bounded down to 0.

When you short an asset, your potential loss has infinite upside. There is no cap to the height that an asset can rise to. Impermanent loss in the context of a range bounded asset carries more similar risk to buying spot whereas in the context of an unbounded asset it is more similar to shorting an asset. While you aren’t “losing” a potentially infinite amount of money, you are losing exposure to potential infinite gains.

Since we are placing an asset (ETHV) with a maximum range from 0 to 250 inside a liquidity pool, the highest the ETHV can go is 250 and our maximum exposure to potential lost gains is 250 * ETHV in the position.

As we know that volatility will settle and regress to a mean, we also know that the potential losses are temporary in a sense. Some may even call them impermanent… This is not exactly why impermanent loss is confusingly named this but it’s a good example of why the name is accurate.

Example Strategy 🎯

With the goal in mind, I would want to accumulate USDC throughout the drop of ETH. This means I want to set my price range for ETHV to trade on the positive side of 100, but making the determination around how high to place that is a bit beyond me. There is also a benefit to selecting a somewhat narrow range so that my position is utilized for the swaps. My understanding is that the swap will be routed through the position with the most narrow, matching range.

Initially, I think of a range from 155 to 175.

I understand this to mean that once ETHV surpasses 155, my position will start to be utilized in swaps. Once ETHV reaches 175, the entire position will be in the form of a stablecoin.

Historically, liquidity providers must provide both sides of the market. With an ability to do single asset deposits based on a range outside the current price, I am essentially able to set a limit sell order for ETHV. This is even better than I expected when I initially considered this strategy using a maximum range liquidity pool. The caveat here is that revenue generated from swap fees will be quite low as the position will not be used until volatility is extremely high.

I think we have a path forward there though.

If ETH moves up in value quickly, ETHV will rise, but according to my goal I do not wish to exit the position in stablecoins. So if ETH shoots up quickly, I will generate trade fees and hold the position. If ETH drops quickly, I will generate trade fees and exit the position for stablecoins to purchase ETH.

Setting a Data Supported Price Range for ETHV 📊

Pricing ETHV on Uniswap V3 from a range of 155 USDC to 175 USDC was a hunch. But to really understand a good price range, we should look back at market activity and find the dips that we would have wanted to buy.

Theoretically, this allows us to identify the range of volatility that we may expect on future dips that we will want to buy.

I do not have this data handy but it is critical to understand the historical value of the implied volatility near the dips that you want to buy. Once this data is accessible and can be analyzed, a more proper range should be identifiable.

Risks 🛑

This video from Andreas M. Antonopoulos covers 5 types of risk in DeFi.

Financial Risk

Counter-party Risk

Contract Risk (Primary and Secondary)

Platform Risk

Compound Risk

The main concern that has come up for me lies in the financial risk area. As the strategy is using Volmex along with another well known protocol, Uniswap, I can accept the counter-party risk. Assuming that we trust Volmex Labs contracts (they’ve been audited by Certik and Coinspect), I can accept the contract risk. Platform risk as described by Andreas refers to Ethereum ecosystems concerns such as high gas fees that lead to cascading issues — this is worth considering alongside the financial risk.

Compound risk has to do with considering all of these risks in relation to each other and how they may impact each other.

This is not a comprehensive list of risks but I find it a helpful framework to work through when considering how to think about a strategy.

This is a summarized version of the full article, go check it out if you want to learn more!

Thanks for reading 👋

Go thank danner!

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