Hedge both assets underlying an LP token - and - hedge impermanent loss
Step 1: Deposit your collateral to secure the borrow positions
Step 2: Borrow both the assets underlying the LP token
Step 3: Use the Borrowed Asset to Mint LP Tokens
Advanced: Hedging Impermanent Loss
Introduction
The Fringe Finance margin trading and lending platform offers various tools to manage and hedge your financial exposure in the DeFi ecosystem in controlled and nuanced ways. This guide describes how to hedge your exposure to both underlying assets in an LP token and also how to hedge against impermanent loss using the Fringe Borrow facility.
Problem Being Solved
This user guide addresses two similar but different use cases:
Use case 1: As an LP token holder, I want to hedge my exposure to both the assets underlying the LP token so that I don’t lose redemption value if either or both underlying fall in value.
and
Use case 2: Isolate yield exposure: As an LP token holder, I want to hedge my exposure to impermanent loss.
The mechanism described in this user guide also allows you to retain exposure to your existing portfolio of assets - which you can use as collateral to achieve this strategy.
For example, this user guide applies if you hold either a big bag of a meme coin or USDC and wish to deploy this capital to earn net LP yield without being exposed to the underlying assets of the LP token.
The following diagrams present the initial LP exposure and the resultant LP exposure for each use case:
Caption: Initial exposure vs resultant exposure.
As a prospective LP token holder, I want to hedge my exposure to impermanent loss.
The second use case is interesting to almost all liquidity providers.
Caption: Initial exposure vs resultant exposure.
Mechanism Overview
The mechanism for each of these use cases is similar in the following respect:
Using Fringe Finance, you can achieve this strategy through the following steps:
1. Use your existing assets to deposit as collateral on Fringe.
2. Borrow both the assets underlying the LP token.
3. Use the assets to mint the LP tokens on your chosen DEX.
Caption: Mechanism of use case
Given you have now taken a short position on the underlying assets, you are now hedged against the price volatility of the underlying, while you earn LP yield (minus borrowing costs).
To hedge impermanent loss, there is a necessary additional step - to then re-balance the loan positions to reflect the changing DEX pool asset apportionment over time. That’s all.
The instructions to achieve this are described below.
Instructions
This user guide is applicable to all pair DEX pools on all chains.
Before commencing, identify the LP token you wish to acquire. It is necessary that Fringe lists both assets in your chosen DEX pool. For this example, let's assume you want to provide liquidity on the OP/ETH pair.
Decide your capital allocation - the amount of capital you wish to allocate to execute this strategy.
Calculate the apportionment of your capital allocation to be used as collateral to borrow each underlying asset.
To note: This step will not be required with Fringe V3, given Fringe V3 will support pooled collateral.
Typically, when contributing to a DEX liquidity pool, you would use equal values of each asset. Though, with concentrated liquidity pools such as UniV3, this may not be the case if you select price ranges asymmetrical with the most recent price. For the purposes of this example, however, we will assume equal amounts for each underlying asset.
To calculate the collateral required to borrow equal amounts of each underlying asset, the factors are LVR of each collateral asset, LVR of each borrowed asset, your desired safety buffer and your capital allocation.
The calculations are presented in full in the linked Google Sheets calc worksheet, but summarized here:
Given:
collateralVal.A = borrow.A / ((1 - SB) * CollLVR.A * CapLVR.A)
collateralVal.B = borrow.B / ((1 - SB) * CollLVR.B * CapLVR.B)
Constraints:
CollateralVal.A + collateralVal.B = CapitalVal
borrow.A = borrow.B
Therefore, the solution for borrow.A is:
borrow.A = CapitalVal * (1 - SB) * CollLVR.A * CapLVR.A * CollLVR.B * CapLVR.B / (CollLVR.B * CapLVR.B + CollLVR.A * CapLVR.A)
Make your own copy of the linked worksheet (File >> Make a copy) to calculate the following:
how much collateral to use to borrow each asset.
how much of each capital asset to borrow
The calculator will assume a 50:50 split of value between each asset you will use to mint the LP token.
Capital efficiency: The capital efficiency will be a function of the LVR for each asset (collateral and capital) and your chosen Safety Buffer.
i.e. (Borrow.A + borrow.B) = capital allocation * capital efficiency factor.
For this user guide, we will use our own figures.
Step 1: Deposit your collateral to secure the borrow positions
Borrow asset A - OP
Navigate to app.fringe.fi, connect your web3 wallet, and deposit the collateral you wish to use to secure the OP borrow position. In this example, we’re using USDC.e.
1. On Fringe’s Borrow UI collateral list, find the asset you are holding (e.g., USDC.e for our example here), then select "Deposit".
2. Specify the amount to deposit.
3. Confirm the deposit transaction in your web3 wallet.
The deposited collateral will now appear in Fringe.
Step 2: Borrow both the assets underlying the LP token
4. Select "Borrow" on the Fringe Borrow interface for the collateral deposit you wish to borrow against. USDC.e in this case.
5. Choose borrow asset (i.e. OP in our example here) and specify the amount to borrow as calculated by the link worksheet. This amount includes the safety buffer to avoid liquidation.
When ready, press “BORROW” to borrow the specified amount of OP. Confirm the transaction using your web3 wallet.
3. Confirm the borrowing transaction in your web3 wallet.
Now you will have an open borrow position for OP.
Borrow asset B - ETH
If you are using a different collateral asset to borrow ETH, repeat the steps you undertook to borrow OP, but borrow ETH instead. Follow the instructions again for this section Step 1: Borrow both the assets underlying the LP token.
If you intend to use the same collateral asset to secure the borrow position for asset B, Fringe V2 requires you to use a separate wallet to open the borrow position. Use a separate wallet and follow the instructions again from the top of this section Step 1: Borrow both the assets underlying the LP token.
Note: Fringe V3 (due Q4 2024) will not require use of a separate wallet. This is because Fringe V3 supports Pooled Collateral which allows borrow positions to be opened against your mixed pool of collateral.
Step 3: Use the Borrowed Asset to Mint LP Tokens
Use your chosen DEX to supply the borrowed assets to your chosen DEX pool. The borrowed assets will be equal in value.
As mentioned above, if you are supplying to a UniV3-compatible pool and select price ranges asymmetrical with the most recent price, the DEX will expect a different ratio of underlying assets to mint LP tokens.
You have now achieved the use case “hedge my exposure to both the assets underlying the LP token.” The short exposure via the borrowed assets offsets the long exposure from the LP token.
Manage the position
Monitor your Fringe Borrow positions’ collateral ratio to ensure you remain above the liquidation threshold.
If the borrowed asset appreciates significantly in relation to the collateral asset, you may need to add more collateral or partially repay the loan to maintain a safe buffer.
Advanced: Hedging Impermanent Loss
To achieve the second use case described in this user guide “Isolate yield exposure: hedge exposure to impermanent loss”, periodically rebalance the borrow positions to reflect the changing asset ratios in the DEX pool. This dynamic adjustment ensures (near) continuous protection against price fluctuations in both assets.
When you rebalance, you will borrow more or repay some of either or both of the borrowed assets to keep the borrow ratio in proportion to the DEX. Your aim when rebalancing the borrow positions on Fringe will be to keep the borrow positions similar in value to the redemption value for each respective underlying asset of the LP token.
Hedging impermanent loss adds this new step #4 “Rebalance” to the mechanism presented previously:
Caption: Mechanism of use case
This approximates hedging impermanent loss.
This is because you will typically only rebalance as and when the LP underlying asset prices fluctuate relative to one another above a certain threshold.
Why Fringe?
Given Fringe supports a wide range of regular and exotic assets, Fringe offers multiple advantages:
Fringe offers the opportunity to achieve this hedging strategy for a wider range of LP token underlying assets.
When borrowing assets for this strategy, Fringe gives you greater flexibility to retain your exposure to the collateral you use to secure the loan.
The reason Fringe is able to support a wide range of exotic assets is that it has purpose-built security measures which other lending platforms lack. For example, see our New Price Oracle model and our Partial Liquidation model.
Using Fringe also results in lower interest rate volatility - because Fringe employs a unique interest rate model based on a controller that targets a utilization rate. This means that you are better assured against surprise interest rate spikes that are characteristic of other DeFi platforms which employ simplistic interest rate models based on an interest rate curve that is a function of the utilization rate.
And, in the future as more LP token assets are created with a variety of underlying assets, Fringe will always be better placed to satisfy your hedging requirements given our support for a greater range of long-tail assets.
Summary
Fringe Finance allows you to hedge exposure to the underlying assets in LP tokens and even hedge impermanent loss through straightforward DeFi facilities. By using the Fringe Borrow facility, you can protect your investment from adverse price movements, isolate exposure to an LP token’s yield to enhance capital efficiency and potential gains.
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