Delta Neutral Yield with Umami Finance

Previously, fellow frog Yield Aggregator covered the Arbitrum protocol GMX and its source of sustainable yield. Today, we will cover another Arbitrum yield protocol – one that actually takes what GMX did and makes it even better.

Enter Umami Finance.

It was in the good old days of 2021 that OlympusDAO (OHM) was first introduced to the DeFi world. With its novel use of bonding, rebasing, and Protocol Owned Liquidity (POL), OHM began the “DeFi 2.0” revolution. It wasn’t long before OHM had more forks than a fine dining restaurant.

Many of these forks were pretty successful for a time, as they (3,3)’d their way to sky-high token prices and multi-million dollar treasuries. Unfortunately, 2021 gave way to 2022, and with it came pessimistic narratives for the CT hivemind. Without new money coming in to subsidize the 100000% APRs, many OHM forks quickly collapsed. OHM fork season was over as fast as it began.

Umami started out as an OHM fork. However, unlike most OHM forks, Umami did not collapse. Instead, it reinvented itself. Instead of an OHM fork, it would be a sustainable and risk-hedged source of yields. Out went the million % APRs and in came a zero-emission token and sustainable protocol revenues.

Even though the UMAMI token got killed during the OHM fork collapse, Umami Finance was successful in amassing a strong protocol treasury. It turned out (3,3) was good for something, as bonding and POL meant that instead of renting liquidity, they now owned it and could use it however they wished. Armed with a multi-million dollar treasury, Umami had enough money to make offering yield products feasible. Thanks, OHM. Now let's see what these products look like.

Umami offers two yield products for users, one already released and one due to be released soon.

The released product is known as Marinate. In Marinate, Umami uses its POL in various DeFi products and farms to generate revenue. Half of this revenue is paid daily in wETH to UMAMI stakers, and the other half is added to the protocol treasury. As the treasury gets larger, revenues get larger as well, which further increases yield for UMAMI stakers.

Marinate currently offers 5.43% APR, which grows to 5.58% if you choose to use Umami’s compounder. This option automatically compounds the wETH rewards into more UMAMI, increasing earnings over time.

Although a sustainable 5% APR is not bad in a bear market, it’s probably not enough to get the true degen excited. But 25%? Now we’re talking, and that’s precisely what Umami’s soon-to-be-released product promises.

The Delta Neutral USDC Vault will be Umami’s flagship DeFi product, and it’s a potential game-changer. Imagine Anchor with a higher APR that is also sustainable and has almost zero risk. Yeah, I’m excited too. Let’s talk about how Umami plans to make it happen.

First, let’s address what delta neutral means in the first place. Delta is a number between -1 and 1 that measures the amount an option price moves based on a $1 change in the underlying stock. A delta of -1 would mean that for every $1 the underlying stock increased in value, the option price would decrease by $1. Vice versa, a delta of 1 would mean that for every $1 the underlying stock increased in value, the option price would also increase by $1. Puts always have a delta between -1 and 0, while calls always have a delta between 0 and 1.

A delta neutral strategy is then simply one where multiple positions are balanced so that the total delta equals zero. By being delta neutral, the portfolio is hedged against the risks found in a volatile market. In essence, regardless of which way the market is moving, a delta neutral portfolio is profiting.

Now that we know what being delta neutral means, we can move on to the keys of the master plan: GMX and TracerDAO.

GMX

GMX is a DEX on Arbitrum that specializes in perpetual futures. How does it work? In the words of another Frogs article, it employs a “multi-asset liquidity pool that acts as the counterparty to leveraged future trades.” This counterparty LP is comprised of all the tokens that GMX offers perps on, and it’s represented by the GLP token. Anyone who provides liquidity on GLP receives 70% of GMX’s fees, paid out in esGMX and ETH (or AVAX.) GLP holders currently profit to the tune of a handsome ~20% APR.

However, GLP is not without its risks. Because it’s the counterparty to traders, GLP LPs need traders to lose money. If the traders went on an extended win streak, the asset pool would shrink and the GLP APR would be in bad shape. Fortunately for them, the vast majority of traders lose constantly.

The second and more pertinent risk is GLP’s underlying assets. Although GLP is half composed of stables and half relative stable blue chips like ETH, this is still crypto, and these assets are volatile. Although a crash in the underlying GLP assets wouldn’t be a death sentence for GMX, getting paid in crashing ETH is not ideal.

Umami addresses this risk through TracerDAO Perpetual Pools. Tracer hasn’t gone “mainstream” yet, so there’s a good chance you have no idea what the hell those are. Don’t worry, I’ve got you covered.

Tracer provides infrastructure for decentralized derivatives. Their goal is to bring derivates on-chain and, in the process, democratize access to what has traditionally been a pretty restricted asset class. So far, this effort has manifested itself in their flagship product: Perpetual Pools.

Built on Arbitrum, Perpetual Pools allow people to take perpetual leveraged bets with no chance of liquidation. In short, users deposit USDC to mint L-tokens if they wish to go long or S-tokens if they wish to go short. Once they have their tokens, they can either stake them for some TCR rewards or just hold them, chill, and wait for the move you want to happen. Sounds crazy, I know, but it’s true.

The key to making Perpetual Pools work is unsurprisingly in the design of the pool. At a high level, Perpetual Pools are just liquidity pools holding collateral. The pool always has two sides, long and short, and ownership of this collateral is represented by L-tokens and S-tokens. Price oracles periodically check the price of the underlying asset and transfer funds from the losing side to the winning side. For example, if there was a perpetual pool for ETH, and the price of ETH shot up, some funds from the short side would be transferred to the long side. L-tokens would then be more valuable, and S-tokens would be less valuable.

Now that we know how pools work, we can extrapolate what conditions would lead to a liquidation. Because pool tokens represent ownership over collateral, liquidations would occur if the value of the collateral went to zero. Owning a share of nothing means you own nothing. There are two ways that this could happen: a massive move in either direction that quickly drains the pool or a continuous drain that is not replenished by new funds. Tracer created two mechanisms to prevent this from happening: power leverage and the rebalancing rate.

Power leverage was created to address the risk of a sudden violent move draining the pool. Power leverage is the formula that determines how much collateral is transferred after price movements, and what it does is take away some of the upside in return for limiting the downside, or in their words, “gives returns almost equal to “times” leverage for typical price movements, but dampens returns to extreme price movements so users can never lose 100% of their collateral”.

For visual learners, the formula is:

Where P is a value provided by the price feed. In practice, this leads to a graph that looks like this:

As you can see, with power leverage, you’re not going to get the same outsized returns on extreme price moves, but you’re also never going to get liquidated.

To address the risk of a continuous drain that is never replenished, Tracer created the rebalancing rate. As the imbalance between the pools increase, the rebalancing rate reduces the amount of funds that are transferred from the weak side to the strong side. On the flip side, any move from the strong to the weak side is amplified, creating asymmetric upside for the less collateralized side. This amplified upside incentivizes users to take the less collateralized side until the pool is once again balanced.

Let us now finally get to the main dish and discuss how Umami plans to combine GMX and Tracer to create the Delta Neutral USDC Vault.

Once you understand how GMX and Tracer work, it’s pretty easy to understand how the Umami Vault itself works. Let’s go through it step by step.

• Users deposit USDC into the Vault and receive usdGLP in return.
• The Vault uses the USDC to mint GLP and 3S-ETH/3S-BTC hedging tokens on Tracer.
• GLP does what it does and pays out a nice yield, sourced from the failures of our degenerate brethren, in ETH and esGMX.
• While this is happening, the Tracer pool tokens are constantly rebalanced to ensure delta neutrality.
• At the same time, the Tracer pool tokens are also staked, earning the vault some additional TCR rewards.
• The Vault then converts the ETH and TCR rewards back into USDC and distributes them to users, while the esGMX is re-staked to earn GMX multiplier points, boosting future GLP APR.
• The user can also leave the vault at any point by swapping their usdGLP for stables on Uniswap.

That’s all there is to it. For the user, it’s a passive and safe ~20% APR. In a bear market, you can’t really ask for much more.

Although the USDC Vault is much safer than most DeFi strategies because of its delta neutral disposition, there still do exist some risks that you should be aware of.

• The success of the Vault is heavily reliant on the success of GMX. This is by no means a bad thing, GMX has been successful throughout the bear market and shows no signs of slowing down, but it is true regardless. Any failure for GMX would adversely affect the Vault.

• There is some inherent risk in the Tracer perpetual pools. Because the pools have not yet attracted a ton of liquidity, a big influx of funds from the Vault could throw the pools out of balance, negatively affecting the risk-adjusted returns for Umami. Umami is preventing this in two ways:

1. Limiting the amount of funds allowed into the Vault during the early days.
2. Partnering with hedge funds and institutions to take the other side of the pool.

• Combining these two measures should keep imbalance to a minimum until the Tracer pools organically grow.

• As with all DeFi protocols and strategies, there exists smart contract risk. Thankfully, Umami has been audited by security firm Zokyo. The odds of anything happening are low, but it’s best practice to always have your guard up.

Earning a good non-dilutive yield isn’t easy at the moment. Earning a good non-dilutive yield with extremely low risk is damn near impossible to find. With Umami’s USDC Vault, users are offered exactly that.

Looking toward the future, the USDC Vault has potential beyond just earning a sturdy yield. Prolific threadooors Barry Fried and Haym Solomon have broken this down well in the past, but I’ll provide a quick summary. Because the vault tokens are ERC-4626, they are composable throughout the DeFi ecosystem. Umami plans to take advantage of this by releasing “metavaults” - basically, vaults built on top of vaults. This means that instead of only earning yield from one vault, you can earn yield from multiple vaults within the same vault. Vaultception, if you will.

It sounds crazy and is still long way off, but it’s definitely something to keep an eye on.

If vaults don’t satisfy all your desires, the UMAMI token itself could be worth looking at. With a growing treasury that could explode after fee collection starts for the new stablecoin vault, it is likely that protocol revenue significantly increases. If protocol revenue increases, the reward for UMAMI stakers increases as well. Increased rewards for UMAMI stakers mean increased demand for UMAMI, which further grows the treasury and revenue, increasing demand further, and on and on it goes. With a max supply of just 1M, this positive flywheel could quickly lead to a supply crunch for UMAMI.

If this happens, investors will receive a sustainable cash flow and an appreciating token. The beautiful thing is that one leads to the other. Protocol success equals token success, just like it should.

Regardless of what happens with Umami in the future, it has been great to see the #RealYield trend take off during this bear market. Whether it’s Umami, GMX, Gains Network, or something totally different like Cytus, it is clear that there is a new wave of protocols focused on producing a non-dilutive and sustainable yield. Hopefully this trend continues, and we can continue building DeFi back stronger and healthier than ever.