The Delta Neutral Yield Strategy

25% APY, how is that possible?

Welcome Anon! In my previous article I discussed how to approach DeFi yields, today I will look into a yield strategy that pays out juicy yield in USDC.

Mt. Arbitrum

The DeFi industry is constantly evolving while Ce-DeFi is imploding. Apparently, there is a benefit to having a transparent financial system after all. However, today we are diving into the delta-neutral yield strategy that is generating 25% APY by UMAMI Finance. By now you should already be familiar with how I approach DeFi yields as I touched upon in my previous article. Farming and dumping get tiresome and generating yield that is not to the detriment of token holders will be increasingly adopted as the industry evolves.

What is Delta?

First of all, there is no point diving into the strategy if we don’t understand what it means to be delta neutral. Let’s start with “Delta” which in options trading is how much the option price changes depending on the price changes of the underlying security. If the Delta equals 1 then the price change is fully correlated, a $10 price movement in the underlying security equals a 10$ price move in the options price.

The Delta can range from -1 to 1 measuring the correlation. If the delta is 0.5 then a $1 move in the underlying security incurs a $0.5 options price move. While an option with a -1 delta will incur a decrease in options price for every time the underlying security increases in price.

Call options normally have a positive Delta that ranges from 0.00 to 1.00 while Put options have a negative Delta that ranges from 0.00 to -1.00.

Delta Neutral Strategy

Considering you now have an idea of what Delta is, you can probably guess what being delta neutral means. Essentially, it means that the Delta equals 0. By adopting a Delta neutral strategy you utilize multiple positions that balance positive and negative deltas to make sure it equals zero. Delta neutral strategies are normally used for hedging purposes or profiting from implied volatility or time decay if you’re trading options.

UMAMI Finance rebranded from an OHM fork to a treasury management protocol and is taking full advantage of this strategy. They use a Delta neutral strategy for hedging purposes as they utilize GLP which is the GMX platform liquidity provider token that consists of a basket of assets. I have covered GLP in detail here if you want to explore it further. In that prior article, I highlighted that GLP is a treasury strategy DAOs should seek to adopt. UMAMI Finance is doing so by holding positions in GLP on GMX, which is currently paying out 16.52% APY as I’m writing this.

Note: The point of this article is not to explain what UMAMI is as there are great write-ups about it already. Instead, the focus is on analyzing how the yield is actually provided.

Source: https://gmx.io/earn

Considering GLP consists of a basket of volatile assets it is still susceptible to price decreases. GLP generates its yield through the high volume generated by the GMX platform and taking a bet against traders. If the traders lose money GLP holders profit and vice versa. In a world where we have seen prime degeneracy taking place and people getting wiped out (3AC & Celsius I’m looking at you), UMAMI is opting for Delta neutrality and risk management. Instead of taking aggressive trades trying to run up the treasury, they are hedging the GLP position through TracerDAOs perpetual pools to short assets in the GLP basket to ensure Delta neutrality.

Let’s not forget the fact that a GLP position produces esGMX rewards as well that acts as a multiplier that increases your staking rewards further. These rewards are not currently factored into the APY that will be generated by their USDC vault.

Liquidation-free Perpetual Pools

TracerDAOs perpetual pools are split into two sides where you either take a long position (betting that the price will go up) or a short position (betting that the price will go down). As people put their money in a pool it constantly checks through the use of Chainlink price feeds which side of the pool is winning (by betting on the right direction of the price). By doing so, it consistently moves money to the side of the pool that is winning and further away from the losing side. The money that is moved between the long positions and the short positions can be amplified through leverage.

Leverage is normally a killer as it wipes out people that have taken the wrong position by liquidating them. This is not the case in TracerDAOs perpetual pools due to the sacrifice of some of the winner’s gains to ensure you don’t lose all of your money. However, despite not being liquidated your position can still end up being minuscule and insignificant as an increasing amount of money is moved from your initial position. Operate accordingly. Since the pools are perpetual it means that they operate forever as long as they can consistently retrieve a price feed. Thus, your position exists forever unless you exit it instead of being forcefully liquidated.

The pools allow you to take 3x leverage using BTC and 10x leverage on ETH (although UMAMI sticks to 3x leverage). The leveraged tokens can either be acquired on Balancer or on the native TracerDAO app.

One important point to consider here is that there will be times when these perpetual pools will be imbalanced. There is no way to guarantee an equal 50% consensus between short and long positions. This means that you will be more rewarded through staking by taking a contrarian view and going against the grain. This is done as a balancing act when the market aggressively bets in one direction.

This allows UMAMI to maintain Delta neutrality while still generating yield through the leveraged tokens and the GLP basket profiting from leverage traders on the GMX platform.

Lasting yield

Protocols that aggressively emit their tokens away will indicate a lack of belief in your own token when you want to reward token holders by revenue sharing. What happens when you run out of your own tokens that are most likely finite? Protocols would go out of business and that’s an added risk for their investors.

I talked in my previous article that yields paid out in USDC or coins with staying power á la ETH is the future. While I won’t go into detail as it can be read here one thing to factor in is the operating cost for employees (which is normally the highest cost in decentralized protocols) and grant recipients. If the protocol can generate revenue in a token that actually can be used as a medium of exchange, distributing it to the actors involved would not put any pressure on the token. This would equal less sell pressure on the token and the capital could be used to buy back and burn the token to reward token holders (which in my opinion is a bad deployment of capital in a bull market) or utilize a dividend model to reward stakers and long-term holders. No matter what model protocols opt for, it increases the likelihood of the token representing the actual success of the protocol, which should be beneficial for all parties involved. It will lead to the DAO working hard to get fairly compensated for their efforts of growing the protocol in a sustainable way.

UMAMI Finance capping their vaults will most likely lead to a highly sought-after product as customers pour in to have treasury management run viable strategies for them. However, nothing is risk-free.

Risks

As markets have been duly punishing participants over the last few months, it seems like everybody is on edge waiting for another domino to fall on their head. As with all current DeFi protocols, the main risk is smart contract risk. The Lindy effect is a real thing, especially in the world of crypto. When new protocols turn up, they are a target for hackers as they are being battle-tested on a real-time basis. There is a reason why protocols such as Curve have a strong reputation along wit their moat and it’s because of the Lindy effect. It refers to the longer something has been around, the longer it will likely persist in the future (Bitcoin is a prime example of this).

Treasury Management protocols in UMAMI’s mold will probably turn toward decentralized insurance to mitigate this risk and this should open the door for a secondary thriving insurance market. Although no one has consistently got it right yet as Nexus Mutual has been criticized for not paying out coverage due to various reasons including front-end attacks. However, that is for another article.

A clear and transparent way to generate yield while being aware of the inherent risk the protocols possess is a step in the right direction. This is the DeFi we’ve all been asking for.

UMAMI Finance uses 3x leverage against BTC and ETH to hedge their GLP position. However, while they use TracerDAO to not risk getting liquidated there will be liquidation protection for leveraged perps coming directly to GMX through Dopex's impending Atlantic options.

Atlantic Options x GMX

Among the best things about DeFi is its composability. Bringing great products together to the benefit of your customers is a win-win for all parties involved, more people pour in to use lucrative products while the protocol profits from a growing user base. Dopex has plans to release its novel DeFi product called Atlantic Options. This will enable leverage traders on GMX to insure their positions to prevent them from being liquidated. By taking on 2x leverage on a $1000 ETH position, your liquidation price would naturally be at $500. However, with Atlantic Options this wouldn’t be the case as you would pay a premium to insure your position. This would mean that instead of having a liquidation price of $500 your liquidation price would instead be $0 ensuring you solid liquidation protection.

However, paying the premium + funding for the 2x Leverage ETH position with an Atlantic-insured perp might be seen as a costly procedure. TzTok-Chad himself has mentioned that it would roughly amount to $40 for a 1-week insured position. While $40 is not a small fee if you consider a scenario where you have a 2x leverage position, a $20 move would be enough to break even equalling a 2% move of $ETH.

Note: This is just basic math explaining how an insured leverage perpetual position would work. I would in no way ever recommend that you use leverage if you don’t know what you’re doing. Act responsibly and don’t end up like 3AC.

This allows UMAMI Finance to adopt solid risk management with their customer’s funds while also providing Dopex with a sustainable yield-generating method through leverage traders that want to insure their position.

This only scratches the surface of Atlantic Options and doesn’t address how it allows you to move the collateral out of the option and use it for other purposes enabling better capital efficiency. If you want to explore how it works further 0xSaitama has created a great explainer here.

Conclusion

UMAMI Finance is in a prime position to capitalize on a current DeFi ecosystem that is being scrutinized for unsustainable yield. Having a finance background myself, it is refreshing to see protocols adopt solid risk management in their treasury strategies and look at great products such as GLP. There is a reason why solid risk frameworks have been adopted in the TradFi world. Despite that we are trying to get away from that, there are still many things we can learn that get forgotten in a nascent DeFi industry.

If UMAMI’s USDC vault ends up being a success there is only a matter of time before competition heats up. While the protocol has liquidity capped their vault to make sure they can consistently provide a high yield for their customers’ other protocols will try to do the same to take a slice of the pie, thus diluting the GLP APR. Considering the degenerate nature of the crypto world, other protocols will probably take on increasingly higher leverage to try to outperform UMAMI's strategy. Risking their own capital to attract customers. While it might be profitable for some in the short run there is a reason why the house normally wins against leverage traders in the GMX platform. It might steal customers from UMAMI in the short run or fortify them as reliable treasury managers. Time will tell.

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Disclaimer: All Content on this site is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing on the site constitutes professional and/or financial advice, nor does any information on the site constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. I am just a random degenerate sensei sharing an opinion.