Impermanent Gain with Smilee Finance

AMMs need liquidity to function, and this liquidity comes from liquidity providers (LPs). People who are willing to lock up their assets into liquidity pools so that others can swap in and out with them. As a reward for taking this risk, the LPs earn a certain yield from the trading fees collected by the pool.

While the seasoned yield farmer may have been profitable on their LP’ing ventures, a vast majority of inexperienced LPs ended up making losses, often without realizing how. This is thanks to a phenomenon termed “impermanent loss”.

When providing liquidity through an AMM, a certain amount of your position is lost due to fluctuations in the ratio of assets, and this is known as impermanent loss. The more volatility a trading pair faces, the more an LP loses to IL.

Impermanent loss happens in pools where there’s a standard ratio for providing liquidity (i.e. 50/50 ETH/USDC). The act of trading involves users depositing one token and removing another, so the ratio of assets in the pool will naturally deviate from 50/50 after volatile trading days. Because LPs have a claim to a percentage of the pool, rather than a claim on a set number of each asset, their total holdings go down as arbitrageurs remove small amounts of liquidity by correcting these imbalances.

For this reason, LPs often find that depositing into pools often leaves them with less of their assets than if they had simply held onto their tokens. It is abundantly clear that DEXs and AMMs are here to stay, but how do we tackle the ever present problem of impermanent loss that is plaguing, and often disincentivizing, LPs?

So far, the only way has been for LPs to hope the trading fees they collect as yield are sufficient to offset the impermanent loss. Unfortunately, this hasn’t panned out as expected. Some reports have found that a vast majority of LPs still tend to lose money over time.

So what’s the solution, you may ask?

Smilee finance may have an answer.

Smilee Finance uses a variety of volatility products to turn impermanent loss from a bug into a feature. To create these products, they had to shift the perception of IL.

Look at it this way: consider LP’ing like selling an option. As described above with impermanent loss, the way to be profitable with an LP position is for there to be low volatility. So in options terms, the creation of an LP position is effectively taking a short volatility (i.e. short gamma) position. They take this risk in the hopes that over time, trading fees will be sufficient to offset it - which effectively means a long theta position.

So if the LP taking the short gamma & long theta position is the option seller, who is the buyer?

Previously, a buyer never existed simply because there was no instrument created to be an “options buyer” in this scenario. Smilee finance is now creating that option. So let's go into the general flow of how the product works before diving into the finer details.

Smilee is essentially building a DeFi-specific volatility primitive, hence their products are broadly referred to as Decentralised Volatility Products (DVPs). These DVPs can broadly be divided into 2 types of strategies, long volatility & short volatility. If you are in a vault that’s long volatility you will make money when the market moves regardless of the direction, if you are in the short volatility vaults then you make money through stable market conditions.

But how do the options buyers in this scenario earn their money? The ones who are long volatility? Well it looks a bit like this:

DVPs are utilized by two counterparties: those who are long volatility, and those who are short. Essentially, long volatility DVPs pay a premium to buy options on impermanent loss, and this premium is paid to the short volatility DVPs. In turn, the short volatility DVPs pay impermanent loss based on their LP positions, which is then routed through the engine and paid to the long volatility DVPs. This effectively turns impermanent loss into impermanent gain.

Although DVP vaults can come in multiple forms, they all have similar parameters by which they are defined.

Each vaults has:

• The type of volatility exposure (long volatility or short volatility)
• The pair of tokens (eg. ETH/USDC)
• The payoff formula – this is the strategy behind the DVP and the formulas used to achieve the goal of the vault
• A maturity date
• An auction period

All of this comes together thanks to the liquidity-to-volatility engine. It is a proprietary engine designed by the Smilee Finance team in such a way that both DVPs (long & short) remain perfectly balanced. What one DVP earns is paid by another DVP, ensuring that equilibrium is maintained through all market conditions.

This equilibrium is achieved since the sum of all long and short volatility DVP payoffs is equivalent to the sum of the LP payoff and the impermanent loss, but since impermanent loss is the difference between the LP payoff and an equally weighted portfolio, the formula can be rearranged to show that the sum off the long and short volatility DVPs is exactly equal to the equally weighted portfolio, effectively tackling impermanent loss.

The engine also ensures that the notional values of the long and short volatility DVPs always match, so the odds of an imbalance between the vaults is very unlikely.

To top it off, Smilee leverages liquidity from the DEXs to offer maximum composability. It’s created a brand new DeFi primitive that uses DEXs as the baseplate and Smilee becomes the first money lego on top. Their architecture subsequently allows for a whole suite of protocols to create customized DVPs and other instruments on top of them, adding more pieces to the lego structure.

There are a variety of vaults that can be built on Smilee. There can be direct options vaults where calls, puts, straddles, or any other type of option strategy can be executed. You can also have variance swaps which are very popular in TradFi but will likely be more demanded in DeFi. There can also be insurance vaults where users can get protection against things like depegs or impermanent loss.

While the possibilities of what can be built on Smilee are endless, let’s take a look at two types of vaults that have already been built so you can get a better idea of what Smilee would look like in practice.

The overarching premise of the Real Yield vault is to fairly compensate liquidity providers. As we know, the majority of LPs lose money because the fees they earn cannot compensate for IL. Hence, these Real Yield vaults are built to give a fair return to LPs.

There is an auction period on the Real Yield vaults where LPs can deposit liquidity into the vault in the form of both tokens or a single token. On the other side of the trade is the impermanent gain vault. Users who deposit in that vault are paying a premium in USDC. After maturity, the LPs in the real yield vault receive the premium and their deposited liquidity, minus the impermanent loss.

Now LPs don’t have to rely on unpredictable & unstable yield directly from the DEX, or worry about constantly adjusting their positions and ranges. They get a predefined and transparent payoff which gives more confidence to existing and prospective LPs. This doesn’t just work out for users - it provides a level of reassurance to those who may be on the fence about LP’ing, ultimately resulting in increased liquidity in DeFi.

These vaults are the counterparties to the Real Yield vaults; users in this vault are the option buyers. Users deposit USDC into this vault as a premium to earn the impermanent loss. They deposit during the auction period and once the vaults reach maturity, the impermanent loss on all the positions in the Real Yield vault is transferred. By ‘earning’ the impermanent loss, it is effectively transformed into impermanent gain.

Prospective buyers could have a number of reasons for using these vaults. For starters they will prove to be a great hedging tool for funds or individuals with a substantial amount of naked LP exposure. They can prove to be particularly profitable if a user positions themselves prior to specific events, such as the FOMC meeting or the CPI print. Another useful time is in bearish conditions, where things like stablecoin depegs become common and buying options would be very profitable.

However, the entities that are likely to use this the most are DAOs. DAOs do a lot of LPing with either their own token or tokens of supported projects (Protocol-owned liquidity projects). As a result, they face sizable drawdowns through impermanent loss. Hedging risk through the impermanent gain vaults will likely be a sought after strategy for most DAO treasuries.

But that is not all. As I mentioned earlier, Smilee offers money lego-esque composability, so the impermanent gain vaults can be further expanded to increase potential gain (and also the risks involved). Additional strategies such as up-only or down-only strategies can be added, which is basically choosing a direction of market movement and betting on that, rather than a blanket bet on volatility of any kind. It’s an increase in leverage with appropriately higher returns, but with that comes an equal amount of risk if the market goes against you.

Something to keep in mind if you’re a prospective user of this vault is that a position can be closed at any time. It is not mandatory to wait until maturity. At the time of closing, the position will earn the amount of impermanent loss that is seen up until that moment. The premium paid, however, is forfeited in its entirety.

The Smilee team is very bold in their approach. They are creating a completely new DeFi primitive using existing knowledge of traditional instruments such as options. There are a multitude of options markets in DeFi, but very few have tried to turn the DeFi-native concept of impermanent loss into a product. As a result, they have created a truly unique and DeFi-native options instrument.

While the idea and execution may be top notch, it is important to keep in mind that there are risks involved. Trading volatility products in general are inherently risky because you are exposed to the unpredictable swings of the market, and as is common with all DeFi protocols, there is always the ever-present risk of hacks or exploits.

As it is, we’re still in the very early days of Smilee, and it’s a protocol that would be worth staying on top of. Keep a close eye on their socials to be early to any new developments, and try and get yourself early access to the discord for additional alpha.

All that’s left to do now is gear up & stay vigilant for the launch.