A newspaper released Thursday by a team of crypto researchers hopes to add to a body of work that will eventually identify “Decentralized finance (DeFi) Black-Scholes” – an equation that will allow investors and consumers to appreciate DeFi’s projects all right. and potential profit / loss metrics in popular DeFi vertices like liquidity mining.
Why is such an equation important? At first, liquidity mining is simple enough to explain: in exchange for providing liquidity to automated market makers like Uniswap, consumers are rewarded with trading fees or governing tokens, often named in APY percentages.
However, consumers suffer “imperfect losses” associated with fluctuations in demand for the trading pair, and a simple APY calculation on the user interface front is not sufficient to paint a full picture for what the gains might look like for liquidity providers.
According to research by Tarun Chitra, founder and CEO of risk analysis firm DeFi Gauntlet.Network and one of three co-authors When does the tail wag the dog? Curiosity and market making, The best way to think of liquidity mining is a complex derivative.
Paper Alert ⚠️
Q: Have you thought about maths for the following?
a) Optimal incentive to emit for product farming incentives
b) Hedge loss hedges w / options
c) When do LPs not get rekt?
A: A newspaper from moi, @alexhevans, @GuilleAngeris https://t.co/VeJjtSK038
– Tarun Chitra (@tarunchitra) December 17, 2020
“Most passive investment products often have similar exposure to trivial derivatives. For example, the collapse of the ETF XIV in February 2018 (“volmageddon”) showed how some “passive” and “safe” assets have complex exposure, ”Chitra told Cointelegraph. “Liquidity providing in AMMs is not so different, although it presents a new set of risks for holders. Liquidity providers always balance fees earned (positive income) with large price movement losses (negative, imperfect loss). “
These complications have resulted in the failure of many liquidity mining projects due to over-venting (“1e9% APY is not sustainable, too many LPs and no traders”), or under-venting by developers not offering enough rewards to offsetting discontinuous losses. Ultimately, consumers and developers should “think of farming as the analogue of complex derivatives of manufacturer-take incentives on central exchanges.”
In addition, this new conceptual model can allow liquidity providers to make more sophisticated decisions, as well as more robust architectural frameworks for AMM developers.
“This paper provides a principled way for developers and designers to provide LP forms that make sense,” says Chitra. “APY only makes sense for fixed income assets (bonds), but derivative pricing makes MUCH more sense for something like liquidity provision. Hopefully this is the first in a line of numerous works trying to find the ‘Black-Scholes of DeFi.’ ”
According to Chitra, successfully identifying a DeFi that matches the Black-Scholes model could also be key to adopting a mass DeFi. Developed in the 1980s to help investors find ways to properly value stock options, Black-Scholes led to a huge boom in derivatives trading.
Although it remains to be seen whether a new model can break so cleanly through the complexities of DeFi, this paper seems to be a promising first step.