Rudy DeFi insight — How to Become a GMX GLP Hedging Master
In this article, guest author Thomas Faber from Rudy Capital writes about hedging a liquidity provision on GMX.
Can we agree that if Yoda had an influencer account, no one would listen to him because sanity doesn’t pump the markets enough? Yoda would have known that $LUNA was one Ponzi scheme (yes there were voices of reason on Crypto Twitter but no one wanted to hear them) or that Abracadabra is one contradiction with their VC bashing as they allowed Alameda to borrow millions from $MIM against the $FTT shitcoin even though on-chain liquidity was too low. Shoutout to the Frog Nation, we feel you.
That’s why we want to advocate for reasonable DeFi investments. Well, the term ‘reasonable’ obviously leaves a lot of room for interpretation and depends on your specific investment thesis.
But one thing in particular has been the fate of many investors this year:
A lack of drawdown control.
Far too many people have put their money into the market, hoping for a supercycle, for prices to rise forever. In a mix of confirmation bias and hubris, the laws of market cycles were gladly ignored and crypto was declared to be decoupled from other asset classes. Until it hit so hard that even people not invested in crypto felt a cold shiver down their spine.
It’s time to give DeFi strategies with effective drawdown control serious attention. 15% APR with near-zero volatility and downside protection hasn’t sounded boring to anyone since June. Right?
First and foremost, we need to think of everything that can go wrong. Then about returns.
We’d like to demonstrate how drawdown-controlled DeFi investing can look like by an example strategy that includes the well-known protocol GMX, a perpetual exchange that lets you long or short BTC, ETH, LINK and UNI with up to 50x leverage on Arbitrum (GMX is also available on Avalanche).
GMX nuts and bolts
On GMX you can make or lose money as a trader or you engage as the counterparty to traders by providing them with liquidity. In simple terms, traders borrow from a liquidity pool that anyone can provide liquidity to. The liquidity providers (LPs) receive the majority of trading fees from the platform. As the counterparty, LPs also win when traders lose and vice versa. The majority of the return as an LP is activity-driven (trading volume of GMX traders) and not based on reward tokens, making it sustainable and suitable for the real yield narrative. Contrary to many other liquidity pools, GLP does not suffer from impermanent loss.
In practice, LPs mint or redeem GLP, the platform’s liquidity provider token that reflects the index of assets in the pool. It can be minted using any index asset and burnt to redeem any index asset. GLP minting and redemption fees are dynamically modified to provide LPs and traders with an incentive to move actual asset weights in the direction of the defined target weights. However, the target weights are only incentivized but not forced through active rebalancing by the platform.
On Arbitrum, LP rewards are divided into ETH and escrowed GMX (esGMX). esGMX rewards are not guaranteed and are used by the platform to keep LPs incentivized in times of low trading fees. The drawback of esGMX rewards is that they are subject to vesting of 365 days and cannot be sold directly.
Instead of the typical Automated Market Maker (AMM) model, GMX uses dynamic aggregated price feeds from Chainlink oracles and others, smoothing price fluctuations and eliminating slippage in market orders. This is because GMX obtains prices in real time from the different price feeds to provide traders with best execution without arbitrageurs making up the price difference between different DEXs.
You’ve understood the inner workings of GMX and minted your first GLP tokens. Congrats, your position is now generating fees. But remember, we want to step up the game. Nothing tops a peaceful sleep at night while markets are burning. Or as Albert Einstein used to say
Sounds good? Read on.
As a GLP token holder, you’re still exposed to the price movements of the tokens in the liquidity pool (ETH, BTC, UNI and LINK). Now, in order to keep potential drawdowns in check, we need to hedge against unwanted price changes. To effectively do that, our delta hedge must reflect the weights of the tokens in the pool.
ETH makes up most of the pool with a weight of 32.54% as of now, followed by BTC with 16.52%. LINK and UNI make up 0.86% and 0.80% respectively. The rest of the pool is held in stablecoins (primarily USDC) and can be ignored for hedging purposes.
Let’s say we’re investing $100,000 as a LP, we can break our initial token exposure down as follows:
ETH exposure = ($100,000 * 32.54%) / $1,207.88 ≈ 26.94 ETH
BTC exposure = ($100,000 * 16.52%) / $16,637.20 ≈ 0.99 BTC
LINK exposure = ($100,000 * 0.86%) / $6.13 ≈ 140 LINK
UNI exposure = ($100,000 * 0.8%) / $5.78 ≈ 138 UNI
To effectively neutralize our delta, we need to short these exact amounts. This can be done in a variety of ways through e.g. GMX’s own leveraged perpetuals or centralized exchanges like OKX and Binance.
So I just ape into GLP and open a few shorts? Glad you asked. Not quite.
Hedged GLP is an actively managed strategy that needs to be mastered.
To become a master, all moving parts must be understood and observed. Only then we’ll have a viable system that allows us to take the right actions.
The moving parts
There’s many moving parts and metrics that we can pay attention to. But accounting for the following provides us with the most important information.
- GLP price: the price of GLP is based on the total worth of all tokens in the pool and factors in pending profits and losses from all currently opened positions, divided by the total GLP supply
- GLP amount: the amount of GLP tokens you’re currently staking
- Token weights: the value of tokens of a particular asset in the pool (ETH, BTC, UNI etc.) in relation to the total value of tokens of all assets in the pool.
- Long exposures: the amount of tokens of an asset you’re long
- Short exposures: the amount of tokens of an asset you’re short
- Net exposures: your long exposure minus your short exposure of an asset
- Total position value: the total value of your long and short positions. This value should remain as constant as possible, as we’re minimizing our directional exposure.
- Gross APR: the return you receive as LP in relation to the capital provided to the GLP pool
- Net APR: the return you receive as LP in relation to the capital provided to the GLP pool and the hedge
- Funding payments: the payments you make or receive for maintaining your short position
- Liquidation prices: the estimated prices at which your short positions will get liquidated. Applies to leveraged positions only. Note: leverage is a very useful tool for increasing capital efficiency, but it comes with higher operational risk and complexity.
- Short capital ratio: the share of capital tied up in the short (including PnL) in relation to the strategy’s total capital. It’s basically a metric for measuring capital efficiency. The higher your short capital ratio, the lower your Net APR, because that capital is not “working”.
These twelve metrics give you full control over your position by allowing you to measure accurate net performance and monitor all relevant parameters that may indicate risks to your position or returns.
You’re probably wondering now how the heck you’re going to monitor all this stuff. Read on.
The hard and most typical way is to record things in a spreadsheet. You may open several browser tabs and then just copy the values from the interfaces and run your calculations in Excel. But that’s tedious, prone to error and doesn’t provide you with real-time, accurate and synchronized data. Manual performance tracking and risk monitoring also comes along with delayed intervention on immediate threats or market anomalies that risk your position or returns.
We got so fed up with manual tracking that we ended up building our own automated solution for it. Using on-chain data, we track everything relevant to the long side of the strategy such as the GLP price, APR, earned rewards as well as the weights and balances of the tokens in the GLP pool. These data points then build the basis for various metrics and visualizations in our dashboard.
The “Overview” section consists of overall metrics and visualizations that provide a quick 360 degree view on the overall strategy.
The “Position Info” provides us with a more detailed view on the value of our GLP position as well as the rewards earned.
In addition to on-chain data, we also use the APIs of several centralized exchanges such as Binance and OKX to track our hedge positions. Apart from short amounts and price feeds, we are interested in funding rates, as these have an impact on the performance of the strategy.
If we now combine the insights from the on-chain data and those of the hedges from e.g. centralized exchanges, we get an exact picture of the best-practice execution. Our overview provides us with detailed information on current weights as well as long, short and net amounts per asset. This information serves as a basis for our delta hedge. No more manual calculations needed. If my Token Amount (Net) is -0.7 ETH, I’m 0.7 ETH over short. A rebalancing of our ETH short would then require closing our short by 0.7 ETH.
Once your monitoring system is set up and correctly displaying all relevant metrics, you can actively make adjustments to the strategy. To hedge your GLP delta risk, continuous short rebalancing is required to match the current asset weights in the pool. There’s no one way to it but a few approaches can be considered (not claim of completeness):
- Time-based rebalancing, e.g. every 24h or every week
- Trigger-based rebalancing, e.g. once the GLP delta net exposure exceeds 2%
- No rebalancing, potentially viable in a long-term investment setting as weights could return to initial weights when shorts were created
Keep in mind, every act of rebalancing may lock in profits or losses created through an imperfect hedge by constantly changing GLP weights.
Time-based and event-based rebalancing would require you to rebalance, no matter the profit/loss consequences of rebalancing.
This is something you need to be comfortable with when following these approaches. Which one you eventually choose obviously depends on your general investment thesis, drawdown tolerance, return expectations and so on.
We’re currently backtesting a variety of hedging approaches to get closer to an optimal delta hedge. In this context, we are also investigating the extent to which a gamma hedge can be possible and useful.
Hedged GLP is certainly one of the most interesting strategies out there at the moment. Platform fees and LP rewards generated by actual trading activity is powerful in times when token rewards suffer from low token prices and inflationary sell pressure. Still, there are quite a few things that need to be considered to not to expose yourself to unknown risks and establish effective drawdown control.
A 360 degree view of your GLP and short position is crucial for success. In case you’re interested in our dashboard solution, let us know!
We’re still in development and highly appreciate any feedback you might have to make it even better.
Our intention is to provide these kind of functionality not only for GLP but also to other DeFi strategy types such as concentrated liquidity pools from Uniswap V3. Starting out as an internal tool, we now plan to roll it out for public use.
Until then, anon. Control deez drawdowns!
The classification of GMX according to the ITC
Economic Purpose (EEP): GMX is listed as Governance Token (EEP22NT02) due to its governance functionality.
Industry Type (EIN): The issuer of GMX is active in the field of Decentralized Derivatives, Synthetic Assets and Insurance (EIN06DF03).
Technological Setup (TTS): GMX is an Other Application Layer Token (TTS42ZZ). The Class “Avalanche ERC-20 Standard Token” captures every Token that is implemented by means of the ERC-20 Standard on top of the Avalanche blockchain.
Legal Clam (LLC): GMX does not entitle its holder to any legal claim or rights against the issuing organization, therefore it is listed as a No-Claim Token (LLC31).
Issuer Type (LIT): The dimension “Issuer Type” provides information on the nature of the issuer of the token. GMX’s platform is built by a team of programmers and engineers that make up the core contributor community. Its Issuer Type is an Application Layer Protocol (LIT62AL).
Regulatory Framework (EU) (REU): The dimension “Regulatory Status EU” provides information of the potential classification of a token according to the European Commission’s proposal for a Regulation on Markets in Crypto Assets (MiCA, Regulation Proposal COM/2020/593 final). GMX qualifies as an Utility Token (REU52) according to the definition provided in Article 3 (5) of Regulation Proposal COM/2020/593 final.
The International Token Standardization Association (ITSA) e.V.
The International Token Standardization Association (ITSA) e.V. is a not-for-profit association of German law that aims at promoting the development and implementation of comprehensive market standards for the identification, classification, and analysis of DLT- and blockchain-based cryptographic tokens. As an independent industry membership body, ITSA unites over 100 international associated founding members from various interest groups. In order to increase transparency and safety on global token markets, ITSA currently develops and implements the International Token Identification Number (ITIN) as a market standard for the identification of cryptographic tokens, the International Token Classification (ITC) as a standard framework for the classification of cryptographic tokens according to their inherent characteristics. ITSA then adds the identified and classified token to the world’s largest register for tokens in our Tokenbase.
- The International Token Identification Number (ITIN) is a 9-digit alphanumeric technical identifier for both fungible and non-fungible DLT-based tokens. Thanks to its underlying Uniform Token Locator (UTL), ITIN presents a unique and fork-resilient identification of tokens. The ITIN also allows for the connecting and matching of other media and data to the token, such as legal contracts or price data, and increases safety and operational transparency when handling these tokens.
- The International Token Classification (ITC) is a multi-dimensional, expandable framework for the classification of tokens. Current dimensions include technological, economic, legal, and regulatory dimensions with multiple sub-dimensions. By mid-2021, there will be at least two new dimensions added, including a tax dimension. So far, our classification framework has been applied to 99% of the token market according to market capitalization of classified tokens.
- ITSA’s Tokenbase currently holds data on over 4000 tokens. Tokenbase is a holistic database for the analysis of tokens and combines our identification and classification data with market and blockchain data from external providers. Third-party data of several partners is already integrated, and API access is also in development.
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