CompliFi LP Token Meets Real World
This post is for general information purposes only. It does not constitute investment advice or a recommendation or solicitation to buy or sell any investment, or to issue or trade derivatives, and should not be used in the evaluation of the merits of any financial or investment decision.
TL; DR
- Providing liquidity to CompliFi is a similar experience to most other AMMs, but its LP token’s value proposition is distinct and unique — a largely market neutral, risk-managed revenue stream from derivative market making.
- Below, we offer some informal intuition on how the LP token accrues value and the risks that it poses.
- The protocol has now been live long enough to generate interesting data. We examine how the LP token has performed so far and compare it to our pre-launch simulations.
A Look Inside the CompliFi AMM Pool
Adding liquidity to a CompliFi AMM pool is a simple process — in a single transaction, you send USDC to the protocol and receive LP tokens in return. Behind the scenes however, things are a little more complex. CompliFi pools do not contain USDC, but rather long and the short position tokens in a particular derivative.
When you add USDC liquidity, several actions are executed atomically. First, your USDC is used to mint equal amounts of long and short derivative tokens. Next, a swap is performed in order to match token proportion in your portfolio to that in the pool (if different). Then finally, your derivatives enter the pool and LP tokens are issued.
Like with most AMMs, CompliFi LP tokens are a proportional claim on the pool’s contents. What these contents are and how they behave, however, are fundamentally different.
LP Token Value Path
Consider the LP token for the ETH-USDC Uniswap pool. From a static perspective, it is effectively a portfolio of ETH and USDC. As such, it carries market risk — if the price of ETH falls, the LP token’s value will decline and then arbitrage trades will erode it even further. To claw back the losses, ETH price will need to recover. If it does, pool contents will come back to their original state plus trading fees earned along the way. Naturally, market risk also has a flip side — if ETH price rises, so will LP value, no matter the inevitable arbitrage.
Now consider a CompliFi derivative pool, using the ETHx5 derivative as an example. In its initial state, the pool contains equal amounts of ETHx5 Up and Down tokens — a fully hedged portfolio. If the price of ETH falls, the Up token will lose value, but the Down token will rise to compensate.
Now, let’s plot a hypothetical path for LP value:
- The pool starts in a fully hedged state. A trader removes Up tokens from the pool and adds more Down tokens. The pool receives trading fees, takes on ETHx5 Down exposure. The more exposure, the higher the trading fee. Fixed exposure limits are never exceeded.
- Time passes, ETH price changes and the pool reprices its derivatives using an on-chain price feed. Suppose ETH rises, and the pool’s net ETHx5 Down position loses value. The blow will be cushioned by the trading fee received for taking on this risk. In some cases, the fee will exceed the loss from market exposure, in others not.
- Next, another trader comes and performs another swap. The pool earns more trading fees, and its risk position changes again. Let’s say that this swap swings the pool the other way — into net ETHx5 UP exposure.
- Time passes, ETH price changes. Let’s suppose again that it rises. This time however, the pool’s risk position pays off and the unhedged ETHx5 Up tokens rise in value, on top of the trading fees earned.
Extrapolating from these steps, LP value path could be viewed as a series of market bets against traders, which are limited in size and can either be won or lost, combined with a strictly positive stream of trading fees. For the AMM to continually lose these market bets, the traders it faces would need a crystal ball. There will certainly be periods when markets do favour traders over LPs, but over time the situation should be reasonably balanced. It is the trading fee revenue that gives LPs the edge — it keeps on adding value as market bets cancel each other out.
Theory Meets Reality
During the design phase of the AMM, we conducted numerous simulations to see how LP value performs under various market conditions and trading patterns. Now, we are in the privileged position to be able to compare our hypothesis with the AMM’s performance in the real world. The amount of available data is still very limited, but nonetheless significant.
Let’s start with simulations, performed on the ETHx5 LP token. We took historical ETH prices and combined them with a set of random trading patterns for the same period. This gave us a range of different exposure paths for a pool faced with identical market conditions.
Here is what we got for the reasonably steady month of August 2020. Remember, LP tokens start their life at 1 USDC.
Now to spice things up, here is January 2018.
It quickly becomes evident that the key risk for a pool is to get caught with a lot of wrong exposure at the moment of a violent price change. Over time however, the steady stream of trading fees rebuilds value and probability starts to work in LPs’ favour.
Now to the real world. Here, we use data from our second series of derivatives, giving us a timeframe from May 1 to May 17, 2021. We have chosen not use data from our first derivative series, since volumes at the time were very small and sporadic.
Faced with different market dynamics in their respective underlying assets, LP tokens performed consistently and in line with expectations. It is also important to keep in mind that, due to high transaction costs on Ethereum, trading CompliFi derivatives in amounts under about $3000 was not really viable. As a result, LPs missed out on a significant portion of potential trading fee revenue. Our upcoming move to Polygon L2 should address this problem.
Let us emphasise again that real world data is in short supply and risks are still to be properly quantified. However, even assuming current LP token values stay constant from here until the end of the month, this gives an annualised return of 59% across all pools and a range of 18% to 120%. If this performance proves sustainable, then as a passive income product that does not require a market view, CompliFi LP token will likely have few peers.
As ever, please remember that decentralised derivatives are an early experimental product. Even if you have a solid fundamental understanding of financial engineering (which you absolutely should have to even consider committing capital to such instruments), you may still lose money for any number of reasons. As a rule of thumb, please assume that you will lose all of the capital you put in.
