Automated LP Management with Logarithm Finance

The most recent improvement to DEXs was “concentrated liquidity,” where LPs supply tokens within a narrow and predefined price range, earning fees in return. First introduced by Uniswap V3’s CLAMM model (concentrated liquidity automated market maker), it has since caught on in a big way, and many more DEXs have adopted CLAMM or something similar.

Concentrated liquidity is a lot more efficient than having all liquidity offered between 0 and infinity. Offering liquidity within more narrow and relevant price ranges means there’s much less slippage and faster execution of trades. While this is a great development for DEXs overall, there are still a couple big problems that need to be sorted out.

First, CLAMMs require a ton of active management for maximum capital efficiency. Say you’re providing ETH/USDC liquidity at a price range of 1800-2200. If ETH goes below 1800 USDC or above 2200 USDC, your ETH and USDC are then sitting idle, and you no longer earn a share of the trading fees until the price is back within your range. Two problems appear:

First, this leads to an inefficient use of both capital and time. Either your capital is sitting idle in a DeFi world of high APYs, or you take the time to go into Uni V3, withdraw your ETH and USDC, and re-deposit them at a different price range. Even this is capital inefficient, as you're spending a lot on fees in the process, especially on mainnet.

Second, the ever-present problem of impermanent loss (IL). I’ll keep the explanation here brief as you’re probably familiar with IL already: say you’re providing liquidity for ETH and USDC. You have to deposit an equal dollar amount for both, but you’ll end up with more of the underperforming asset and less of the outperforming asset over time. This would be fine if the divergence between the two assets corrected itself over time, but almost universally, arbitrageurs will step in and balance the pool - leaving you heavily weighted towards the underperforming asset, and missing out on gains when the outperformer appreciates in value.

The problems outlined above are what Logarithm aims to solve, saving users time and money in the process.

First, let’s do a quick intro to Logarithm. Based on Arbitrum, Logarithm manages liquidity on CLAMMs such as UniV3, seeking to maximize trading fees and minimize IL. That means if you want to provide liquidity on UniV3, no longer do you have to watch your position like a hawk and potentially spend a lot of fees to adjust your provisioning range when the price moves. Instead, you’ll be able to deposit your tokens into a Logarithm vault, and they’ll do all the legwork for you with their automated strategies.

That solves the time inefficiency dilemma, but the IL dilemma persists – and frankly, it’s a lot more challenging. Logarithm is taking this on by incorporating a dynamic hedge as part of their LP strategy. So, on top of managing LP positions, they include an additional hedge with the goal of minimizing IL.

The ability to hedge against IL is itself a new opportunity in DeFi, and Logarithm is among the first projects to use it. While most other hedging attempts have involved using options and money markets, these have inefficiencies of their own. While DeFi options have a bright future, they’re currently very illiquid and relatively expensive. Money markets, on the other hand, take up a lot of assets as you have to overcollateralize the borrowed position which is used as the hedge.

The third and newest IL-hedging mechanism is perp DEXs like GMX, where you can easily hedge an asset with a leveraged long or short, and easily integrate it into a vault strategy. At this point, this is by far the simplest and most capital efficient way to hedge against something as dynamic as IL.

Now, let’s get into Logarithm’s debut product: Nautilus Vaults, which will be managed and hedged LP positions on Uniswap V3.

Nautilus Vaults make LPing a much better experience in several ways. To use the vault, instead of depositing a token pair like you would in a DEX, you’ll only have to deposit USDC. Logarithm does all the rest for you:

• Converts the USDC into both tokens in the LP pair
• Provides liquidity on UniV3
• Earns trading fees by adjusting price ranges as necessary
• Hedges IL via actively managed perp positions on GMX

Note that the price ranges as well as the hedge are both dynamic. That means that both are automatically adjusted as needed depending on market conditions.

For the LP position, the adjustments are made to keep the money in the highest-volume price range. The reason is simple: more volume = more fees. If that sounds too simple, that’s because it is! The downside of being where the action is is that more volume earns more fees, but the volatility also creates more IL, which oftentimes outweighs the earned fees. That’s where the hedging comes in.

The hedge position is primarily adjusted based on market volatility. Again, more volatility = more IL. That’s because the more you’re swapping in and out of each token in a token pair, the more frequently you’re buying the underperforming asset and selling the outperforming asset. So, the hedge is increased during times of high volatility and decreased during calmer periods.

Another way Nautilus vaults hedge is by narrowing or widening the LP position’s price range. The goal here is once again to limit the amount of volatility, and therefore IL. When volatility picks up, the range automatically widens, which means your portion of the overall trading volume (and therefore IL) shrinks. And when there’s less volatility, the range automatically narrows, which means you’re making up a larger share of volume and fees.

Bringing together all of these features is Logarithm Beacon – a smart contract that stores all sorts of historical data (price, volatility, fees, funding rates, etc.) to base position and hedging adjustments off of in the future. This means that the protocol will continuously improve as it gathers more data – a great example of machine learning being put to good use. Essentially, this is Logarithm’s core feature, and it’s the reason the platform can be fully autonomous while many vault services are still run at least partially by humans.

Another exciting product slated for a Q3 launch is Nautilus GIGA Vaults, which takes the “being where the action is” approach to the next level. GIGA Vaults have many of the same characteristics as original Nautilus Vaults, except for one key trait: they move liquidity to the token pair with the most active volume. That means users earn top-tier fee returns plus the benefit of being hedged against all that extra IL.

As we’ll see in the roadmap, Logarithm plans on incentivizing users to deposit liquidity by offering token emissions to boost vault returns. This will be done via their native LOG token, which is set to launch in the coming months. At first, LOG will be a governance token, but there’s potential to use it to earn real yield paid in ETH if the holders decide to vote for it. This yield would be a portion of fees earned by the protocol via users’ LP positions, and it would be passed directly to LOG stakers.

Overall, Vaults are just the beginning for Logarithm. DeFi tends to innovate at a rapid pace, which the team understands, and as such they’ve already begun preparing for the future. The long term goal for Vaults is that they’ll serve as a base layer for all sorts of other products. Their primary functions will be to deepen liquidity and return more capital to users, and above all else, create the most efficient markets possible.

Taking a more granular view, the team at Logarithm has set a very aggressive schedule over the remainder of 2023, and there’s certainly a lot to look forward to.

First, we have the launch of the first UniV3 Nautilus Vault coming up in June. Over the remainder of Q2, we’ll be hearing about partnerships (word on the street is Camelot and GMX are a couple targets), and the $LOG token will undergo its private sale.

For Q3, Logarithm will be audited, the $LOG token public sale will commence along with $LOG incentivization via liquidity mining, and GIGA Vaults will be launched.

Q4 could be the biggest of all, with several exciting features expected to go live. First, this is when Logarithm begins to expand their platform. Namely, they’ll initiate cross-strategy execution and smart liquidity routing, which means users’ assets will be deposited and hedged across different DEXs and strategies. Another product slated to go live in Q4 is Leveraged Nautilus Vaults. Finally, this is when Beacon will go live, strengthening their overall allocation/hedging system.

Q1 2024 will continue Logarithm’s expansion as they look to go multi-chain, seeking out more opportunities for yield and LPing. This is also when the team expects to apply for grants to further build out the Logarithm ecosystem.

Logarithm is an ambitious project that has the potential to be a key factor in building capital efficiency in DeFi. If we want to attract institutional capital to web3, we need markets that can absorb lots of volume with relative ease. While CLAMMs such as UniV3 are a step in the right direction, Logarithm takes it to another level by not only efficiently managing CLAMM liquidity to earn fees but also hedging against IL at the same time. We’re excited to watch this team execute and be a part of DeFi’s path forward.

Note: This report was prepared in collaboration with Logarithm Finance