Mechanics of Pseudo Market-Neutral Strategy
Last updated
Last updated
Pseudo Market-Neutral Strategy is a yield farming strategy that does not take side on the market at the beginning. It is a strategy built on Leveraged Yield Farming, which is a position consisting of both equity (what the user originally owns) and debt (what the user borrows from the protocol), combining together to increase the share portion in a Liquidity Pool resulting in a higher yield after deducting the borrowing interests.
Liquidity miners earn returns by providing a pair of token liquidity to a Liquidity Pool (LP), collecting both the transaction fee as well as the farm reward. Investment on liquidity mining may suffer impermanent loss when the price of two assets change, regardless of the direction. Pseudo Market-Neutral Strategy could effectively minimize price effect when the price fluctuates.
Before diving into neutral strategies, let’s briefly cover what Long and Short are.
A Long position refers to the purchase of an asset with the expectation that it will increase in value; the more the asset appreciates, the more the position gains. Users can either be owning the asset directly or investing in derivatives that will appreciate in value together with the asset itself.
A Short position refers to the investment that bets on the value of the asset dropping; the more the asset depreciates, the more the position gains. Users can either be short-selling an asset directly or investing in derivatives that will appreciate in value opposite to the underlying asset itself.
Bob did not hold any BTC and he held a negative view on the trend of BTC in the forthcoming. Bob borrowed 1 BTC from the market with interest of 10% p.a. and sold it at a market price of USD50,000 on day 1.
On day 30, BTC dropped to USD40,000, Bob decided to close his position. He bought 1 BTC in the market with USD40,000 and returned 1 BTC to the lender, In addition, he had to pay for the interest of borrowing: (USD40,000+USD50,000) / 2 x 10% x 30 / 365 days.
Bob's total return = Gain in position value - Borrowing interest = (USD50,000 - USD40,000) - [(USD40,000+USD50,000) / 2 x 10% x 30 / 365 days] = USD10,000 - USD370 = USD9,630
Smart investors could also earn even if they are bearish to the market. In this case, the more the price of BTC drops, the more Bob’s short position gains.
It is now time to move on to the concept of market-neutral, which is when the Long portion is equal to the Short portion.
To create a Pseudo Market-Neutral Strategy, you first have to pick a pair of stable coin and non-stable coin, such as CRO-USDC or SINGLE-USDC. The pair of assets is to be put in a Liquidity Pool (LP) in a Decentralized Exchange (DEX) to acquire income brought from transaction fees and farm rewards from the DEX.
It is recommended to start with a 2x to 3x leverage level (Single Finance’s default is 3x) for new users, as we consider it is the most risk-reward effective in most of the scenarios. Pseudo Market Neutral Strategy is not applicable to the leveraged yield farming built under 2x as the Long and Short position on non-stable coin cannot be net off (you will find the hints in below NEIL’s example), while the leverage far higher than 3x (i.e. >=4x) is exposed to high liquidation risk (we will discuss liquidation later).
Take an example of NEIL, BUZZ and MICHAEL who all intend to create a leveraged yield farming strategy of CRO-USDC in 3x (i.e. inject USD1,000 capital each and borrow a further USD2,000 equal value Tokens from a protocol to farm) with different setups:
USDC price is constant at $1
CRO/USDC = 0.5
c. MICHAEL deploys the strategy by borrowing USDC
Okay, now we all know their positions under different setups, in the next step we will put focus on comparing their investment outlook, equity value and liquidation threshold.
The equity values of their LP against price change are then summarised as follows:
It is obvious that MICHAEL and BUZZ are taking a Long and Short position respectively on the CRO (non-stable token) while NEIL is taking a more hedged position with larger stability of the equity value.
If the price of CRO dropped significantly, BUZZ would relatively earn a lot; if alternatively the price of CRO raised significantly, MICHAEL would be the winner. According to the predicted scenarios of bullish, bearish or stable, users with different views can use corresponding strategies to farm a LP. It is however not the smartest way to bet on sides by using yield farming as impermanent loss usually happens, thus experienced investors would instead use simple long or short strategies to reduce the investment transactional cost.
In the DeFi history, yield farming was invented as the DEXs reward the asset owners who provide liquidity to the liquidity pool. Yield farming was born to be a tool for the users to earn the commision income (i.e. transaction fee and farming reward) for providing the asset for trading, in another sense it would be more like a passive earning approach in which the uncertainty should be minimized. The uncertainties mentioned here refer to equity value fluctuation and liquidation risk.
The Pseudo Market Neutral Strategy makes a good balance on equity value fluctuation during bullish, bearish or stable market scenarios, and so does liquidation risk.
Leveraged yield farming utilizes a powerful invention in the traditional financial world, “Borrowing”, to multiply the reward. Those protocols closely monitor the debt position of the borrowers, protecting the capital of those lenders who offer their assets for borrowing. One of the key monitoring indicators is “Debt Ratio”.
“Debt Ratio” is simply derived from “Total Debt over Total Asset”.
Take NEIL’s 3x position as an example:
NEIL’s Equity: USD1000 eqv. NEIL’s Liability: USD2000 eqv. NEIL’s Asset: USD3000 eqv.
Debt Ratio = liability / asset = 2000/3000 = 66.67%
In case the Debt Ratio reaches 100%, theoretically NEIL can still sell all his assets to repay the debts. In practice, however, we need some buffer as a safety net. Normally the debt ratio threshold will be set at around 80%, once it crosses the line, our Stop Loss bot will execute the order to sell all the assets to repay the debt, returning the remaining balance to the borrower (mostly it is under 10% of investment principal).
Now you should thoroughly understand the importance of controlling the liquidation risk well. Let’s go through the example of NEIL, BUZZ and MICHAEL related to liquidation.
Assuming liquidation is to be executed at 80% debt ratio for the 3x scenario, NEIL can withstand around 83% upward price fluctuation while BUZZ can only withstand 45% upward and MICHAEL can only withstand 30% downward. That’s the power of Pseudo Neutral Market Strategy on leveraged yield farming.
Experienced yield farmers or financial specialists may question: “If the Pseudo Neutral Market Strategy is fully-hedged, there should be no change on equity value when price moves, it is however not the case of NEIL as shown above”.
YES!!! The above concern is justified, and we are going to explain more in the following.
Remember in the previous example that we have mentioned “NEIL’s initial net position on crypto assets”?
Single Finance Lab tells no lies that the “fully market neutral” is only for the initial moment when a position is opened and it would slightly deviate from “fully neutral” once the prices change (but sure it is still much stabler than BUZZ or MICHAEL’s portfolio) as the numbers of both tokens in the LP would be adjusted by the arbitrage activity carried by Automatic Market Maker (AMM) according the formula x*y = k.
To deal with it, rebalancing is one of the most effective ways to go as it could resume a “fully market neutral” position at that moment, to extend the safety range.
Before Single Finance, users can also rebalance their portfolio by: close their whole LYF position open a new LYF position by their own effort.
With Single Finance, the whole world becomes “SINGLE CLICK” with many flexibilities. Let’s see the comparison below:
Apart from convenience, there are also lots of benefits and flexibilities Single Finance brings to the universe by applying the same leveraged Pseudo Market Neutral Strategy:
