Market Neutral Liquidity
More tradable markets for traders, more protection for LPs
Last updated
More tradable markets for traders, more protection for LPs
Last updated
Pre-requisite:
In traditional finance, Market neutrality is a risk-minimizing strategy that entails a portfolio manager picking long and short positions so they gain in either market direction.
Why the need for market neutral liquidity:
Oracle-based trading models with oracle price feeds remove virtual AMMs reliance on market efficiency to maintain their price discovery, as well as the risk of wrong funding rates in extreme market conditions. While oracle-based price feeds are able to provide minimal-slippage trading, they are subject to certain risks under volatile market conditions (risk-free toxic order flows), which greatly limits the number of tradable markets.
Under a fair market model, every single trade that traders make should technically have some impact on price or extra costs paid to the market or counterparties (albeit minimal most of the time). Otherwise, in a vanilla oracle-based trading model, a trader can take advantage of the slippage and exploit the liquidity pool easily for assets with relatively low market cap/liquidity depth (say $1B market cap).
Furthermore, as the liquidity pool is trading against all the active traders as a whole, LPs are playing as the passive market maker. Under different market conditions, a diligent market maker should be able to adjust their net exposure accordingly — and the common technique in TradFi market-making is to deploy market-neutral strategies.
Imagine a volatile or single-directional market condition. Since the liquidity pool is acting as the passive market maker (counterparty), if there is no mechanism to balance out the extreme long-short ratio, active traders can exploit the liquidity pool (e.g., during a market collapse).
To solve those two problems, Derivio achieved programmable market-neutrality for liquidity pools — a liquidity provider can be thought of as running a market-neutral market-making strategy on perp & options trading without any complication — as simple as one click.
Perpetual future:
Derivio's perpetual markets charge the oversubscribed at extreme and distribute to undersubscribed. This attracts arbitrageurs so the long-short ratio converges to a balanced state. Derivio’s dynamic funding rate design is different from any existing funding rate design for CEXs/DEXs, given that it is based on LSR.
Under normal market conditions, the funding curve remains at 0. Whenever there is a single directional market condition or some trader makes orders that move the market towards a highly skewed direction, the funding curve creates arbitrage opportunities for active traders to come in and take the opposite direction (often combined with delta-neutral hedging), thus the LSR between active traders will converge towards an optimal balance. Since the liquidity pool acts as the market maker (counter-party) against all active traders (and all active traders as a whole have a neutral bet on the market), the liquidity pool’s exposure will converge to being market neutral by design (on average) even during different market conditions.
Digital options: Derivio introduces a novel dynamic payout curve that is calculated for every block with an efficient implementation. By adjusting the payout dynamically, the traders can have a fair payout while the liquidity pool can be protected by balancing the long-short ratio when there is an extreme market condition (won’t be exploited and lose a lot of money).
Derivio uses a variant of time-weighted CFMM on long short payout to balance the long-short exposure -- when the long-short ratio is balanced among active traders, both sides have a juicy payout (~90%). When the long-short ratio is imbalanced among active traders, the majority side will have a lower payout and the minority side will have a higher payout.
In imbalanced circumstances, the lost risk of LP is well controlled since the oversubscribed side would receive a low payout%, and the traders who take the minority side would be encouraged through high payouts. Conclusion:
Market-neutral liquidity refers to the ability of liquidity pools to self-rebalance and converge to a market-neutral state under uni-directional or volatile market conditions, thus providing robust protection for liquidity providers, while generating organic market-making yield. Meanwhile, by introducing these mechanisms, Derivio allows a wide range of markets to be introduced, while optimizing the risk & manual intervention.
