LVR Capture

How we tranche liquidity

Our rehypothecation technique has two parts:

1. Keep active liquidity in the AMM where it can collect swap fees

2. Keep inactive liquidity in the rehypothecation vaults.

But predicting which price ticks in the AMM will be active and which won't is rather difficult. If we knew that, we'd be running a liquid fund. Fortunately, when Uniswap V4 comes out with hooks, we can hook into the AMM to do this perfectly but until then we have to instead estimate a range of ticks that will likely be active.

This means we can't perfectly capture all the potential rehypothecation yield, but we can get close. This does mean there will be times when unexpected price swings will move the price out of our active ticks and we'll miss out on a few swap fees. It turns out that this is not only okay, it is sometimes even profitable to do. This profit is called LVR capture and is distributed to our depositors.

Active Range

We specify a range of prices called the Active Range. Any rehypothecated liquidity that falls into this range is put back into the AMM to collect swap fees. This active range is based on the expected price volatility between now and the next time we move the active range. In backtests, this simple strategy captures 99% of swap fees. So for almost all pools this is less than a 1% yield difference, which is easily compensated by rehypothecation yields.

This active range setup is similar to an actively managed concentrated LP strategy however because we only allocate the liquidity that you've actually designated for this specific range of prices, your risk is the same as just providing liquidity to your overall position (which is typically wider and less extreme). Therefore this is a way to get the capital efficiency of ultra-narrow concentrated positions with the safety of a wider LP range.

Loss-Vs-Rebalancing (LVR)

But sometimes not capturing the swap fee is actually profitable. There is a concept in AMM circles called Loss-Vs-Rebalancing which compares how much money you would make by not swapping against a trader, letting the price move without you, and then swapping your own token balances to match the AMM's curve equation balance at the new price. This strategy always outperforms being an AMM LP, but is purely theoretical because it's impossible to achieve in practice without perfect information and instantaneous execution speed. However the concept is valuable and informs us of a different way to make money which is by capturing some LVR profits through intelligently rebalancing the active range.

Rebalancing

The active range needs to be adjusted frequently to continually contain the ticks that are actively market making. We call this adjustment of the active range a rebalance. Each rebalance will shuffle tokens out of rehypothecation vaults into the newly active ticks and close some liquidity positions to move those tokens back into rehypothecation vaults.

We typically rebalance due to two conditions:

1. When enough time has passed and the current price has moved too close to the edge of our active range. This is an LVR-free rebalance.

2. When the price has moved significantly out of our active range. This is an LVR-capturing rebalance.

LVR-free rebalances are simple. We've captured all the swap fees, and just want to shuffle some liquidity around to make sure we continue doing that.

LVR-Capturing Rebalances

LVR-capturing rebalances are more complicated because our re-deposited liquidity positions are now out of range. This means we have to close those positions, open new ones, and swap tokens to to adjust our token balances to fit the AMM curve equation at the new token balance. But notice that this is exactly the definition of LVR. In fact, this swap and re-deposit will leave us with extra value! This extra value is precisely LVR and is distributed back to the liquidity positions that lost out on the swap fees. If this LVR is greater than the swap fees they missed, then this was actually profitable for them!

In our backtests, our LVR captures basically net out against the missed swaps; however for certain pools like pegged assets this can be incredibly profitable. If you LVR-captured according to our strategy during the USDC depeg, you would have made more than three times your annual returns from swap fees alone.

Risk

Ironically, this type of active range, rebalancing, LVR-capturing set up is safer than a regular LP. In normal operation, there is no difference in principal value between this setup and a regular LP. However, if one of the tokens gets completely rugged and goes to zero, the LVR capturing setup would retain more of the un-rugged token and return much more value back to the unfortunate depositor.