Issues in Derivative Automated Market Makers

Derivative automated market makers (AMM) present a new series of unsolved issues. Traditional methods of derivative market making is currently not done by liquidity pools due to the unbounded computational costs of portfolio variables. This leads to market mispricings whose long term viability is in question.

The introduction of automated market makers like Uniswap has proven out a model for bootstrapping onchain liquidity for decentralized exchanges (DEX). Prior to AMMs onchain liquidity was fragmented leading users to prefer centralized exchanges for their ability to provide better execution even with their cumbersome onboarding requirements.

AMMs allowed anyone to provide liquidity and be compensated as market maker in a passive manner. Prior to AMMs it was easier to be a market maker on a centralized exchange, after AMMs market making removed most operational overhead and required simply providing capital.

As decentralized finance (DeFi) usage grows the need to parcel out risk and returns emerges as it has in traditional financial markets, in fact this is seen by several such protocols both live and in development.

Derivatives derive their value from the price of an underlying asset using any combination of terms that two willing parties would agree to. This creates the flexibility to repackage the risk and return features of one or more underlying assets.

Derivatives products such as options and warrants give holders the right but not the obligation to buy or sell an underlying asset. With their ability to provide high capital efficiency they can be used as a form of insurance or to create structured products when combined with other instruments creating a more ideal tradeoff between risk and return for the consumer of such products.

Delta is the correlation between price change with the underlying and derivative asset. Derivative market makers generally seek to maintain a portfolio delta of 0 (delta neutral) in order to not be subjected to the risk of market movements. Having a delta neutral liquidity pool allows liquidity providers to harvest volatility without being subject to impermanent loss. Minimising impermanent loss would make such liquidity pools more appealing to liquidity providers seeking to get exposure to an uncorrelated asset class (volatility harvesting) compared with AMMs that have impermanent loss and therefore have more overlapping risk factors with the underlying assets.

In order to delta hedge, the liquidity pool needs to be aware of it’s portfolio delta. Portfolio delta is calculated by summing the weighted delta of each position currently open. Once an AMM has it’s portfolio delta it can incentivize a delta neutral portfolio by quoting positions that bring the portfolio towards delta neutral cheaper than positions that move it away. Doing this onchain is problematic due to unbounded computation costs that grow linearly with the number of positions carried by the liquidity pool at any point.

A possible solution would be an oracle that observes the state of the liquidity pool and provides in the computed liquidity pool delta. Such a solution would need to be resistant to fraud and improper calculation which would lead to undesired effects such as improper pricing.

Thesis:

  • Existing onchain derivative AMMs have structural flaws
  • Delta hedging by liquidity pools can mitigate issues of impermanent loss
  • Offloading expensive computation to oracles can enable onchain Delta hedging

Topics:

  • Off chain computation and verification
  • Handling unbounded computation onchain
  • Impermanent loss solutions
  • Liquidity Pools
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