What is the Market-Neutral (Pseudo-Delta-Neutral Strategy)?
Some veteran alpacas should already be familiar with the concept. We’ve written about this strategy in the past, which you can find in our Alpaca Academy here and our yield farming calculator here.
A Market-Neutral Strategy (Pseudo-Delta-Neutral) is a leveraged yield farming strategy where you can yield farm high APY pairs while minimizing your risk by hedging out market exposure. The Automated Vault eliminates market risk by borrowing and the deploying an optimal combination of assets, and rebalancing them for you to target a neutral exposure. Or if we put it in alpaca language: high yield and low risk.
This is achieved by borrowing assets at optimal sizing and deploy them into an LP position to achieve a zero net market exposure on the volatile asset in a token pair. In the previous versions of Automated Vaults, this is done through two LYF positions due to our smart contract limitation that only allowed borrowing of one asset type in each position. In AVv3, we have made the code more efficient where a single LP position can borrow multiple assets, thus achieving the same results.
Notes on AV's exposure:
In the short term, the exposure in an AVv3 could appear more "extreme" than what it used to be on the previous versions of AV. This is simply due to the nature of how CL DEX works. When the asset price moves to the edge of the LP range, the LP position ends up with almost one asset in its position (and completely in 1 asset when it's out of range.) This behavior is in a stark contrast to the UNIv2 where the exposure shift slightly as price move because you are providing LP from 0 to infinity. Hence, there could be a period where the vault's exposure deviate from the target depending on the market condition and the manager's strategy at the time.
How it works
1.) Farming with leverage allows you to earn higher yields. However, it comes with additional risk; Mainly, liquidation risk if the market moves against your position.
Example: If you open a 3x leveraged position on BNB-USDT (borrowing USDT), you will have a 1.5x long exposure on BNB.
2.) With the market-neutral strategy, we seek to eliminate the exposure on the volatile asset (i.e. BNB) by borrowing the right proportion of assets to hedge out the exposure on the volatile asset.
Example: For 3x leverage, the optimal ratio is borrowing 1.5x volatile asset and 0.5x stable asset. As you can see below, with this ratio, we will end up with 1.5x of volatile asset and 1.5x of stable asset (1x from equity + 0.5x from borrowed funds.)
Above scenario works as illustrative example. For UNIv3, it's true if you are creating an LP position with a symmetrical range on the upper and lower range. However, if the range is not symmetrical, the required assets ratio will be different.
With the optimal ratio, the borrowed assets will match exactly what is required to create LPs at 3x equity value. Hence, you achieve market neutral and only have 1x exposure on the equity you bring.
3.) As time passes, the positions will not remain neutral due to the accumulation of compounded earnings, borrowing interest, and price movements of the volatile asset. With the market-neutral strategy, the vault manager will determine, based on the hedging mechanics, when to execute a hedging transaction to reduce the exposure of vault.
4.) In addition to the hedging, we also have a deleverage transaction to act as a fail-safe mechanism that will take a percentage of the vault's assets and use to pay down debt.
5.) One major advantage of using our Automated Vaults vs. manually performing similar strategies is that Automated Vaults running market-neutral strategies will not have liquidation risk. The Automated Vaults' positions will not have connected liquidation bots, or allow liquidation.
However, there is effectively 0 additional risk of bad debt for lenders from turning off liquidation due to our fail-safe mechanism.