Skip to main content

LP Risk and Hedging

Providing liquidity (LP) earns fees, but the other side of that income is inventory risk. This page explains how an LP position behaves in different markets, how the protocol compensates for it, and how to hedge actively.

An LP's real job: market maker​

When price oscillates, the pool does exactly what every trader wishes they could: buy on dips, sell on rallies — each round trip earns both fees and spread. This is the LP's favorite market.

When price trends one way, the pool passively keeps "selling what is rising, and catching what is falling":

  • In a sustained rally: the pool holds fewer and fewer tokens and more and more cash — the longer it rises, the more upside you miss;
  • In a sustained decline: the pool keeps catching the falling token — the deeper it falls, the more depreciating inventory it holds.

This is a market maker's inventory risk: oscillating markets pay you; one-way markets cost you. Professional market makers have exactly one answer — hedge away the directional risk and keep the fee stream.

The fundamental difference from Uniswap v3 range LPing​

A v3 LP picks a price range. Once price leaves the range, the liquidity sits there frozen: break above, and you are left holding the non-appreciating side, permanently missing the move; break below, and you have caught the full falling knife. It amounts to continuously selling insurance against "price leaving the range" — you collect fees along the way, but when the break comes, the loss is fully realized and never comes back automatically.

Our price range follows the current price automatically (with a confirmation window — during the window, price can briefly hug the range edge):

  • There is no "permanently out of range": the range rebuilds around the new price, and the LP stays in the market-making state;
  • The cost changes shape — from a one-time break-out loss into a market maker's inventory wear: manageable, hedgeable, and continuously compensated by income, instead of a one-shot tail event.

The wear has structural compensation​

  • Shallower pools charge higher fees: fees are tiered by pool depth — the shallower the pool, the higher the fee. Volatile, fast-trending assets usually trade in shallower pools, so the ex-ante compensation is already built into the higher fee;
  • Pump-and-dumps pay extra: manipulative turnover that pushes price away from its normal level pays divergence penalties that flow straight into the pool — the more abusive the one-way turnover, the more the pool earns.

Inventory wear is not an unattended cost. An LP's real P&L = fees + penalties − inventory wear − hedging costs (if hedged).

Active hedging: removing the directional risk​

To remove inventory risk entirely, do what professional market makers do: open an opposite perpetual position to cover the side the pool is underweight. As price trends and the pool's exposure drifts, the perp compensates — LP plus hedge together are direction-neutral, quietly harvesting the fee stream.

This play fits our structure best:

  • One account: the LP position and the perp live in the same account, and the spot itself is the margin — no double collateral, no moving funds around;
  • One price source: the hedge leg and the hedged exposure price off the same pool — no extra cross-protocol basis;
  • A v3 LP who wants to hedge must go to a third-party derivatives protocol: an extra layer of basis, a second margin, and one more protocol to trust.

When to rebalance and by how much is a strategy call; nothing in the account structure stands in the way (see Hedging and Neutral Strategies and Portfolio Margin).

LP-specific hedging facilities (Phase 2)​

  • Fee discounts for hedges: perp positions recognized as hedging the holder's own LP exposure get discounts on trading fees and funding — making hedging cheaper. This is more than an LP perk: the cheaper the hedge, the finer-grained the hedging LPs dare to run, the more neutral their exposure, the fewer liquidations and risk events, the more stable the whole protocol — the subsidy buys risk quality for the entire protocol;
  • Tail protection: use our own options to insure LPs against extreme markets — pay an explicit premium, cap the tail;
  • Yield on shares: LPs may use their liquidity shares as backing to sell options and collect premiums.

Current status (honest labels)​

  • Auto-following range (confirmation window), volatility-tiered fees, divergence penalties, unified margin account — these are structures that exist today;
  • The account foundation for active LP hedging exists today: spot + perp + one account is all it takes (on pairs where perpetuals are enabled);
  • The funding discount, tail insurance, and yield-on-shares above are Phase 2 capabilities, with the direction already set.