Welcome back to Lobster Academy 🦞!
In today’s article, we’re going to explore one of the innovative features of Lobster’s algorithm.
As you may know, Lobster’s algorithm incorporates multiple strategies to maximize yield while minimizing risks. Among these, a particularly intriguing approach stands out: the Pseudo Market-Neutral strategy. Despite its complex-sounding name, this strategy is a powerful tool in DeFi, designed to achieve neutral exposure to a specific asset while participating in a liquidity pool. Let’s dive deeper!
Understanding the basics of DeFi is crucial before we delve into the Pseudo Market-Neutral strategy. We recommend revisiting our articles on liquidity pools, Automated Market Makers (AMMs), and impermanent loss for a comprehensive background.
In brief, liquidity provision involves depositing assets generally in a 50:50 ratio into a liquidity pool to generate yield on your investment. These funds facilitate trading on decentralized exchanges, with transaction fees rewarding the liquidity providers.
However, liquidity providers face a phenomenon known as Impermanent Loss (IL). This occurs when the value of the assets in the pool changes compared to their value if held outside the pool. Let’s illustrate with an example:
Example of Impermanent Loss:
Now, let’s apply the Pseudo Market-Neutral strategy.
NB: This example does not take into account the interests generated by the LP nor the interests for the borrowed asset.
Here, the goal is to only be exposed to USDC in the ETH/USDC liquidity pool. Starting with $10,000 in USDC, we are going to neutralize our exposure to ETH’s volatility. We achieve this by borrowing ETH on a lending platform. This corresponds to effectively shorting it, as if ETH drops, you will have to repay less than what you borrowed. This means we’re primarily exposed to USDC as we have:
The trick is to always maintain the equivalence between the long and the short position, despite the market volatility.
So, we have a borrow position on a lending protocol, and a liquidity providing position on Uniswap.
Let’s see what happens when ETH drops:
If ETH drops, the value of the ETH that you borrowed also drops. That means that you now have to payback less than what you borrowed. On the other hand, what you had in the liquidity pool is also down in value. You won on your short (Borrow) and lost on your long (Loan) of exactly the same amount. You are thus market neutral.
Now let’s see what happens when ETH pumps :
If ETH pumps, your loan’s value also goes up meaning that you have to payback more than what you borrowed. With the value of your ETH in the liquidity pool also going up, you won on your long (Loan) and lost on your short (Borrow) of exactly the same amount. In this case, you’re also market neutral.
If you don’t trust me, let me show you an example with maths in the case ETH drops :
Combining the LP value with the remaining collateral, your total is $9969.36, a minimal loss compared to direct liquidity provision without this strategy.
This method is described as “pseudo” market-neutral instead of “market-neutral” because Lobster’s objective is not to completely eliminate exposure to the asset’s volatility. Rather, the goal is to minimize it to avoid affecting the yield.
Lobster offers a simple way to access Pseudo Market-Neutral strategy through its algorithms. They constantly rebalance your borrowed position to make sure that your exposition remains neutral as long as possible. What’s better? You don’t have to do anything as our smart algorithms will automatedly take the best decisions based on market conditions.
The Pseudo Market-Neutral strategy is just one of the many tools Lobster employs to maximize your returns while minimizing your risk. From Arbitration process to Strike price probabilistic approach, we will explain to you everything to have an in-depth understanding of Lobster’s algorithm.
Stay tuned for more insights into our strategies designed to optimize your DeFi investments!
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