With the emergence of tokenized yield markets, users are now given the option of providing liquidity for these new markets. This post aims to highlight some benefits of being an LP (Liquidity Provider) in AMM’s for principal tokens (PTs).
To provide liquidity into a principal token AMM, they deposit an asset pair into the liquidity pool. If a user makes a purchase of discounted principal tokens at 5% in a 6-month term, they would need to provide the equivalent corresponding pair as follows:
In this specific example, the user provides capital with a total invested value of 200 USDC. If the user provides liquidity until the maturity of the term has been reached, the disproportion of the asset pair is effectively canceled due to the fact that the principal token is now redeemable 1:1 in value for the corresponding asset pair. If the liquidity provider ends up with 204 eP:USDC & 1 USDC or the latter 204 USDC & 1 eP:USDC, the overall value is equal.
AMM’s for principal tokens execute programmatically and collect fees from volatility in the market. LPs collect more yield from volatility in the interest rate markets by constantly buying and selling principal tokens in a manner that resembles an automated portfolio manager which optimizes your returns in fixed yields.
When a user provides liquidity by depositing into the AMM, they are effectively buying and selling parts of their principal tokens as the market fluctuates. The buys and sells are executed at the intermediate prices of the overall market price swings. Therefore, if we don’t include the fees earned from providing liquidity, the AMM position has a return that is correlated to the variable yield without as much exposure to the volatility.
This is akin to having an actively traded strategy where every time the PT value goes up (discounted value decreases) the user realizes interest, and every time the PT value goes down (discounted value increases) the user is buying back into the interest, effectively increasing their overall interest rate position.
What sets this apart from a traditional actively traded strategy, is that as rebalancing occurs, the fee is paid towards the rebalancer. In this scenario, the LP is the rebalancer; the LP’er is getting paid fees as they rebalance their portfolio and benefits from quicker realized gains in the event that the discount decays at a faster rate, or a greater overall fixed rate if the discount increases in their overall LP position.
Taking a scenario where the AMM’s discounted price drops from an entry of 10% to the current market discount of 2%, the user’s assets are executing sales at all of the intermediary prices, meaning the user has realized interest early. The LP’er can withdraw at that given moment without having to wait until maturity. Withdrawing the LP assets will have a fixed rate principal token position closer to 2% remaining and roughly a realized base asset closer to 8% at the moment of withdrawal.
This example shows a volatility drag that averaged out the realized interest of the LP’er to 6% in an 8% discount drop. The LP’er still possesses roughly a remaining small proportion of principal tokens at maturity but has realized 6% of the total interest in a significantly shorter time frame.
Depending on the time frame, this could create significantly higher APY for the liquidity provider. If a user enters a 12-month term AMM at a current market condition of 10% discounted principle token and after 2 months the discount decreases to 2%, by withdrawing their position, the user has guaranteed around 4–8% interest (depending on the volatility drag) but has done so in ⅙ of the time. Effectively earning an upfront interest at a rate of roughly anywhere between 24–48% APR.
This decrease in the discount also benefits the users just holding PTs. However, a passive holder of PTs does not benefit from a market increase in fixed rates, rather only benefits from a decrease in fixed rates in the form of realized gains over a quicker time frame. By providing liquidity, the user benefits from both directions that the market moves and from volatility. The LP’er could realize more than 6%-8% in the same time period simply from rebalancing, if the volatility drag is high enough, and in fees as well.
We are actively researching improvements that may further leverage the power of rebalancing. Firstly, we consider that using a Balancer V2 feature called Asset Delegation could be an improvement that would allow the deposited principal to earn variable interest rates. If this upgrade is added, LP’ will be a portfolio that optimizes your return by constantly trading off between variable and fixed rates as they change. Secondly, we are further researching the restructuring of AMMs to handle multiple expiration date PTs at the same time, which would ultimately turn LP into a volatility harvesting bond ladder.
In summary, the V1 AMM design can earn you additional yield on top of your fixed interest rate in all types of market conditions. It functions like an actively rebalanced portfolio that constantly optimizes your fixed-rate position and makes money from the volatility in interest rates. Positions like this were previously only available to large institutional investors because of the inefficiencies of TradFi, but now, sophisticated volatility harvesting bond ladders and fixed-rate portfolios are accessible for anyone anywhere in the world.
As a next step, we plan to do a follow-up post going into further details backing up these assertions. More specifically, we’ll provide charts of the volume drag for the Element tranches, re-derive the Uniswap profitability bounds for Principal Tokens and the AMM we enable, and provide the results of our simulations surrounding how the portfolio rebalancing plays out in practice.
Next Steps — Element Finance Mainnet Launches Tomorrow!
It’s happening! All of our efforts so far have been leading up to this exciting moment. Tomorrow is not only an important milestone for the Element team and community, but it’s also a big step forward for DeFi. Look out for our official launch post tomorrow!
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