Defining Market Neutral Yield Farming

The terms Market Neutral, Delta Neutral and Pseudo-delta Neutral are all common terms in financial markets. The definition of each is typically unique to the underlying financial product. However, the general principle is that of establishing a position which takes out the exposure to the fluctuations in price of the underlying asset. Having a perfectly delta-neutral position is quite challenging in any market. Even in well-established Futures and Futures Options markets; investors will often only make adjustments to ‘rebalance’ their positions back to delta neutral periodically (days / weeks / months).

In the case of the YieldFi protocol there are some key features providing us with a market neutral position. Firstly, we borrow the assets we farm with. This applies to both the single asset and dual asset borrowing models. This means that if we borrow 1,000 FTM to yield farm with, and the price of FTM drops by 99%, it doesn’t matter to us, because we only need to repay 1,000 FTM which we have in the Yield Farm, no matter what the price is.

However, in practice as correlation between the two assets in the yield farm diverges, the position will result in more of one token than the other. So, if the price of FTM increases against USDC, the End User will have perhaps 0.9x the quantity of FTM they started with, and 1.1x the USDC they started with. This means the position is no longer perfectly market neutral. When a yield farmer withdraws from a yield farm and they do not have the benefit of Debt Rebalancing (as we do in the YieldFi protocol), they will simply swap the additional USDC they have for FTM, so they can repay the loan in full. Any shortfalls will be the result of impermanent loss.

As described above we set the Keepers to rebalance -/+2% price change between tokens. So, as token prices within a liquidity pool continue to diverge against each other, the Keepers will rebalance to re-establish the market neutral position. As you can probably tell, this is an improvement, but difficult to call it ‘perfectly’ delta neutral (same with the Futures and Options example above). Therefore, the term pseudo-delta neutral may be used in these cases to acknowledge that it’s close, but not a perfectly delta neutral structure. To reiterate, creating a perfectly delta neutral structure is incredibly challenging even in the most well established and liquid financial markets in the world.

We name our protocol Market Neutral Yield Farming, because by and large the position is not exposed to the movements of the price of the underlying assets, and we have a rebalancing mechanism which is potentially more efficient than those used in traditional financial markets.

Market Neutral Yield Farming positions are still subject to impermanent loss, however, yield farming has grown so dramatically because typically the yield generated from the yield farm exceeds the impermanent loss by a healthy amount (other than during periods of high volatility where token prices lose substantial correlation).

It’s also important to note that impermanent loss is directly correlated and positively/negatively affected by the length of time that the end user is yield farming for. Ie. End User A has been yield farming for a period of 6 months with an average APR of 20% and an impermanent loss of 5% (for the 6 month period) which would equate to a positive return of 5% over the 6 month period. However, End User B has been yield farming the same yield farm for a period of 12 months with an average APR of 20% and although 6 months into yield farming they were exposed to the same 5% impermanent loss as End User A this impermanent loss reduced to only 2% at the end of the 12 months which equated to a return of 18% over the longer period of time. Point being, End User A was exposed to a greater impermanent loss due to the decoupling of the two assets while farming over the shorter period of time. Whereas End User B was exposed to a lower impermanent loss due the 2 assets recoupling positively over the extended period of time.

In summary, the point in time at which the yield farmer exits the position is the determining factor in realizing impermanent loss. Ie if the position is held and the assets positively recouple then impermanent loss no longer exists or can be greatly reduced.