Hedging Exposure to the More Volatile Underlying Asset in an LP Token
Introduction
Fringe Finance margin trading and lending platform offers various tools to manage and hedge your financial exposure in the DeFi ecosystem in controlled and nuanced ways. This guide demonstrates how to hedge the exposure to the more volatile underlying asset in an LP token related to a DEX trading pair using the Fringe Borrow facility.
Problem Being Solved
- As a prospective LP token holder, I want to hedge my exposure to the more volatile asset underlying the LP token depreciating in value.
When providing liquidity to a DEX trading pair, one of the underlying assets is often more volatile. If this asset’s value falls, you realize a loss when redeeming your LP tokens. This strategy protects against that loss by hedging the more volatile asset.
Mechanism Overview
Using Fringe Finance, you can achieve this strategy through the following steps:
1. Acquire the less volatile underlying asset using a portion of your capital.
2. Borrow and short the more volatile underlying asset using the Fringe Borrow facility.
3. Use the assets to mint the LP tokens.
This process ensures that your exposure to the more volatile asset is hedged, thereby protecting against potential losses due to its price decline.
Instructions
Before commencing, identify the LP token you wish to acquire and hedge. Note the underlying assets in the DEX pair and determine which is the more volatile asset you want to hedge.
For this example, let’s assume you want to provide liquidity on the OP/ETH pair, and hedge against OP falling in value (which we will consider the more volatile asset for this example). This user guide is applicable to all DEXes on all chains.
Decide the amount of capital you wish to allocate to the LP token position.
You will likely use one third of your capital to directly acquire ETH, the less volatile asset. You may already hold that asset, in which case no action is required to acquire ETH.
The remaining two-thirds of your capital can be used to borrow OP. For example, if the combined LVR for the OP borrow position is 64% and you want a 20% safety buffer, you can borrow OP worth around 50% of your collateral value. (On Fringe, combined LVR the product of the collateral asset LVR and the capital asset LVR, which are governance parameters.)
So if your total capital is $10,000, you may allocate as follows:
- $3,333 to acquire ETH (or you already hold that amount of ETH)
- $6,667 as collateral to borrow $3,328 worth of OP (~67% of collateral)
This allocation should result in roughly an equivalent value of OP and ETH to mint the LP token.
Note this results in a capital efficiency of around 67% ($6,661 LP token value from $10,000 capital).
Step 1: Acquire the Less Volatile Underlying Asset
Using approximately one-third of your total capital, acquire the less volatile underlying asset in your chosen LP pair. In our example, the LP pair is OP/ETH, and you deem ETH the less volatile asset, acquire ETH with one-third of your capital. You may already be holding ETH, in which case you may consider using those assets.
Step 2: Borrow the More Volatile Underlying Asset
The remaining two thirds of capital will be used as collateral to borrow OP (which we’re deeming the more volatile asset in this example) on Fringe. The exact amount you can borrow depends on the loan-to-value ratio (LVR) for OP and your collateral asset and your desired safety buffer to avoid liquidation.
Navigate to app.fringe.fi, connect your web3 wallet, and deposit the remaining capital as collateral on Fringe. This capital will be used to borrow the more volatile asset (i.e. OP in our example).
1. On Fringe’s Borrow UI collateral list, find the asset you are holding (e.g., USDC.e for our example here), then select “Deposit”.
2. Specify the amount to deposit.
3. Confirm the deposit transaction in your web3 wallet.
4. Select “Borrow” on the Fringe Borrow interface for the collateral deposit you wish to borrow against. USDC.e in this case.
5. Choose the more volatile asset (e.g., OP) and specify the amount to borrow, ensuring a safety margin to avoid liquidation.
- Calculate the borrowing amount to use approximately two-thirds of your deposited collateral, considering the loan-to-value ratio (LVR) and your desired safety factor.
In the example below, we’ve chosen to borrow 100 OP ($250.50), which is less than the full borrowing capacity (129.34 OP) of the collateral deposit.
i.e. the amount shown as follows:
This results in a Safety Buffer of 22.69% -
which allows the collateral asset vs loan asset to fall in value 22.69% before the position becomes subject to liquidation.
To note: Your collateral’s borrowing capacity is a function of the collateral value multiplied by the loan-to-value ratio of the collateral asset and capital asset. Both of these are Fringe governance parameters.
When ready, press “BORROW” to borrow the specified amount of OP. Confirm the transaction using your web3 wallet.
6. Confirm the borrowing transaction in your web3 wallet.
Now you will have an open borrow position for OP.
Step 3: Use the Borrowed Asset to Mint LP Tokens
1. Combine the borrowed/shorted OP with the initially acquired ETH to mint the LP tokens. This process should result in a similar value of the more volatile asset (shorted OP) and the less volatile asset (ETH), thereby creating the LP tokens. However, if you are supplying to a UniV3-compatible pool, your selected price range can result in asymmetrical pair deposits, therefore a 1:1 ratio may not apply.
The short exposure to the more volatile asset via borrowing offsets the long exposure from the LP token.
Capital Efficiency
By following this strategy:
- You use one-third of your capital to acquire the less volatile asset.
- You use the remaining two-thirds as collateral to borrow the more volatile asset, ensuring a suitable margin to avoid liquidation.
- This approach results in an approximate 67% capital efficiency, depending on the LVR and your chosen safety factor.
Manage the position
Monitor your Fringe Borrow position collateral ratio to ensure you remain above the liquidation threshold.
If OP appreciates significantly, you may need to add more collateral or partially repay the loan to maintain a safe buffer.
Why Fringe?
Given Fringe supports a wide range of regular and exotic assets, Fringe offers multiple advantages:
- Fringe offers the opportunity to achieve this hedging strategy for a wider range of LP token assets.
- When borrowing assets for this strategy, Fringe gives you greater flexibility to retain your exposure to the collateral you use to secure the loan.
The reason Fringe is able to support a wide range of exotic assets is that it has purpose-built security measures which other lending platforms lack. For example, see our New Price Oracle model and our Partial Liquidation model.
Using Fringe also results in lower interest rate volatility — because Fringe employs a unique interest rate model based on a controller that targets a utilization rate. This means that you are better assured against surprise interest rate spikes that are characteristic of other DeFi platforms which employ simplistic interest rate models based on an interest rate curve that is a function of the utilization rate.
And, in the future as more LP token assets are created with a variety of underlying assets, Fringe will always be better placed to satisfy your hedging requirements given our support for a greater range of long-tail assets.
Summary
Fringe Finance allows you to hedge exposure to the more volatile underlying asset in LP tokens through straightforward DeFi facilities. By using the Fringe Borrow facility, you can protect your investment from adverse price movements, maintaining capital efficiency and potential gains.
