How To Hedge Against Declining Interest Rates Using Uniswap v3
Institutional finance players are not SIMP’s for degen plays to earn passive income and are mainly limited to LPing in the usual, i.e., Curve, Convex, Aave, and Compound.
An Example of 3CRV Interest Rate Cash-Covered Call Options
There are several fixed-income solutions to hedge the fluctuating returns of curve LP positions like APWine, etc, that offer fixed income products for risk-averse investors to earn a fixed income and risk-tolerant investors to speculate on the CRV interest rates. This mechanism has a severe scalability issue and hence, most fixed income protocols have not been able to scale and reach the levels that they wanted. To put it simply, it’s the chicken and egg problem:
- No risk-averse lender = speculators cannot buy yield tokens
- No speculators = risk-averse lender cannot earn fixed income
Ultimately, everybody wants to hedge against low trading fees of the respective CRV pool, but is it possible in a “non-degen” way?
The short answer is yes, but we need to first dive a little bit into Curve Finance and understand how Curve prices its LP tokens. If you are already aware, you may skip the next two paragraphs.
Understanding Curve Finance
Curve is a decentralized exchange, originally designed to provide liquidity for stable coins and now for any similar and even non-related pegged assets in their v2 pools. Curve’s main purpose is to make it easy and cheap to exchange one stablecoin into another.
For example, you will find pools that have two or more stable coins pegged to the same fiat currency. When you provide liquidity into one of these pools, you will receive Curve pool tokens (LP tokens) in return, which entitle you to a portion of the trading fees in that pool.
The Virtual Price Of The 3CRV LP Token
In simple terms, the virtual price of the 3CRV LP token is determined by the total $value of USDT, USDC and DAI in the pool divided by the total number of issued 3CRV pool tokens. The premium that 3CRV LP has over 1 LP token represents the expected value of future yield that one can earn in a year by being a liquidity provider at any point of time “t”.
Hedging 3CRV Interest Rates Using Perpetual Uniswap v3 Options
The solution is inspired by an article of Guillaume Lambert who is being quoted below:
“Perpetual Uniswap v3 Options can be deployed right now between any two assets (think beyond stablecoin-token pairs), for any expiration time (not just 1DTE), at any delta (not just ATM), and without the need to deploy an intermediary protocol.”
The payoff of a Uniswap v3 LP position behaves like a cash-secured put or a covered call. As a result it should be theoretically possible to sell a cash covered option for anything that can be represented in the form of an ERC20.
Since the the virtual price of the 3CRV Pool Token is a representative of the premium it has over other USD pegged stable coins like DAI, USDC and USDT as a result of the trading fees accrued to its liquidity providers, one can use the same logic provided by Guillaume Lambert and apply it to hedge a shortfall in trading fees accrued to 3CRV LPs.
Not just 3CRV, but any earnings of any Curve LP token like tricrypto can be hedged against using Uniswap v3. The 3POOL token is one of the most popular base pairs on Curve Finance with several stablecoins like FRAX, MIM and MAI using it. On Polygon, stablecoins can take it 1 step further and LP in the am3CRV pool which lends the unutilised funds in Aave for maximum capital efficiency.
Any token and any pair means that technically, you can create an option for the price of anything and since the change in the virtual price of 3CRV pool token is a representation of the performance of the pool in terms of trading fees, we can use the same logic and apply it towards selling 3CRV covered call options to hedge against degrading interest rates in the form of trading fees. This not only applies to the 3POOL but is theoretically possible for any LP token.
Yield On Top Of Yield — USDC/3CRV Concentrated Liquidity On Uniswap v3 To Hedge Downside Of 3CRV Interest Rates
Assumptions: Let us assume that an investor wants to LP in the 3CRV pool for a period of 1 week and wants an APR of at least 3% for that period.
Due to the current market conditions, the APR of 3CRV is only around 1.5% to 2% and is not expected to be high. In order to make some gains due to the poor performance of the virtual price of 3CRV, the investor can use the following strategy:
Example: creating a 7DTE, 30δ Uniswap v3 option on USDC/3CRV
The annual volatility of the 3CRV virtual price is ~2.6% and the current price is ~$1.02. Based on this information, selling a covered call option on USD/3CRV with a 7DTE and 30δ would look something like the image below. There is no need for a market maker on the other end as well and, as a result, anybody can do this right now without any external dependencies.
Below are the parameters:
Current Price = 1.0200
Upper Tick = 1.023529
Lower Tick = 1.011835
DTE = 7 Days
Delta = 30δ
One thing to bear in mind is that theoretically due to curve’s amplification coefficient, the price of 3CRV will always increase. However, due to the nature of the uniswap v3 curve, it is possible for the price of 3CRV to fluctuate. If the 1 BPS pool is opted for in Uniswap v3, it would be an arbitrageurs dream and it is an easy way to constantly keep the price steady and earn money while doing the same.
As long as there is a decent amount of liquidity on Uniswap v3 of USDC/3CRV, it would be extremely easy to hedge against downside in a way that almost mimics a fixed rate of return as you are giving up a potential upside in the form of Uniswap v3 LP positions and also reducing downside by collecting trading fees.