Whitepaper
Abstract
Alpha Vaults was built using an LP Strategy calling Passive Rebalancing. Passive Rebalancing was introduced by Charm on 3rd May 2021, and became one of the most forked, and most frequently used strategy to manage liquidity. The strategy does not use swaps, and relies entirely on changes in the market price to manage liquidity. It improves performance by receiving (rather than paying) swap fees, avoiding price impact, and avoiding MEV.
The strategy's ability to increase liquidity and improve performance was proven during 3+ years of continuous operation on Mainnet and L2, without any security incidences or operating issues. This paper describes how Passive Rebalancing works, and discuss its wider implications.
Introduction
Managing liquidity on Uniswap V3 can be difficult. For example, if LPs deposit $1000 of ETH and $1000 of USDC and the price moves, their position will no longer be balanced in a 50:50 ratio, which means they are more likely to earn less Fee Income*, and incur more Capital Loss**.
To bring the positions back to a 50:50 ratio, LPs will have to Rebalance - i.e. remove liquidity from the old positions and redeposit it into new positions. An LP Strategy determines how and when to Rebalance, so that when the price moves, LPs can continue to earn Fee Income at lower Capital Loss.
Passive rebalancing is an LP strategy where the inventory it manages always converges to a 50:50 ratio. In the long-run, LPs are expected to earn higher Fees Income and lower Capital Loss.
* Compared to a Full Range Strategy.
** Capital Loss is realised and unrealised Impermanent Loss. For simplicity, Capital Loss will be used inter-changeably with Impermanent Loss in this whitepaper.
Passive Rebalancing overview
Passive Rebalancing works by always trying to sell the asset causing the vault's inventory ratio to depart from 50:50, so that over time, the ratio will converge toward 50:50 as the Market Price changes. This is the key mechanism used by Alpha Vaults to lower impermanent loss.
Passive Rebalancing do not use swaps, and only relies on changes in the market price to get back to a 50:50 ratio. The strategy collects (rather than paying) swap fees, avoid price impact, and avoid MEV. This is the key mechanism used by Alpha Vaults to improve performance.
Passive Rebalancing has two main parameters:
Base Threshold (B)
Limit Threshold (L)
The thresholds maintain two Liquidity Positions:
A Base Order symmetric around the Update Price X, in the tick range [X-B, X+B]. This will deposit liquidity in a 50:50 ratio, and any token that are undeposited will be placed as a limit order. This order increases the likelihood of higher Fee Income.
A Limit Order just above or below the the Update Price. It will be a single-token order in the tick range [X-L, X], or [X, X+L], depending on which token is undeposited. This order reduces the likelihood of Capital Loss.
Some numerical examples are provided below.
Example 1 - Vault has excess USDC
Assuming the vault manages liquidity for a USDC/ETH pool, and Rebalances when the Market Price of ETH in USDC is 150 ticks. The Update Price will be 150, and if B = 50 and L = 20, the range [100, 200] will be chosen as the base order, and [130, 150] as the limit order.
Assuming the vault manages 1 ETH and 160 USDC in total just before Rebalance.
At Rebalance:
The vault will deposit 1 ETH and 150 USDC into the Base Order, with 10 USDC left over.
It will deposit 10 USDC into the Limit Order.
If the Market Price decrease from 150 ticks, the swappers in the pool will sell 10 USDC to ETH, and the vault will get closer to a 50:50 ratio without requiring the manager or the LP to perform a swap themselves.
If the Market Price increase from 150 ticks, more ETH will be converted to USDC, and the vault will attempt to sell even more USDC at the next Rebalance.
Steps 1 to 4 will be repeated at each rebalance until the vault gets to a 50:50 ratio, or if the vault has excess ETH.
Example 2 - Vault has excess ETH
Assuming the vault Rebalances when the Market Price is 180 ticks. The Update Price will be 180, and if B and L remain the same, the range [130, 230] will be chosen as the Base Order, and [180, 200] as the Limit Order.
Assuming the vault holds 1.2 ETH and 90 USDC just before Rebalance.
At Rebalance:
The Strategy will deposit 0.5 ETH and 90 USDC into the Base Order, with 0.7 ETH left over.
It will deposit 0.7 ETH into a Limit Order between [180, 200].
If the market price increase from 180 ticks at the next Rebalance, the swappers within the pool will sell 0.7 ETH to USDC, and the vault will get closer to a 50:50 ratio without requiring the manager or the LP to perform a swap themselves.
If the market price decreases from 180 ticks, more USDC will be converted to ETH, and the vault will attempt to sell even more ETH at the next Rebalances.
Steps 1 to 4 will be repeated until the vault gets to a 50:50 ratio, or if the vault has excess USDC.
Implications
Alpha Vault's LP Strategy is open-source, decentralized, and executed using a transparent set of rules. This means liquidity can be managed on-chain, and passive investment vehicles can be created for Liquidity Providers (LP). These passive investment vehicles are called Passive Vaults:
The following summarises the relationships between the Passive Vaults created by Alpha Vaults, and other types of passive investments:
Investors can deposit into a passive vault if they believe DeFi trading volumes will increase. They do not need to actively manage their positions.
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