In this paper, we describe a generalized, non-custodial, fungible protocol for the implementation of a total return swap that hedges liquidity providers' (LPs) exposure to impermanent loss (IL) in liquidity pools of decentralized exchanges (DEXs). By paying a fixed funding rate, LPs can hedge out any IL exposure and can be confident in receiving the original value of their investment, along with accrued trading fees, when they withdraw liquidity.
1.1.1 Decentralized Exchanges (DEXs) DEXs are decentralized exchanges for digital assets, allowing investors to seamlessly trade between crypto currencies, without the need for a traditional order book-based centralized exchange DEXs typically have three participants:
1.1.2 Automated Market Makers (AMMs) AMMS are smart contracts that hold liquidity reserves (or liquidity pools) that traders can trade against. These reserves are funded by liquidity providers (LPs). AMM protocols use a formulaic approach to determine the price of an asset. Constant Function Market Makers (CFMMs) are a specific, and the most widely used, type of AMMs that were designed by the crypto community. The term ****“constant function” refers to the fact that any trade must change the reserves in such a way that the product of those reserves remains unchanged.
There are three main types of DEXs/CFMMs:
Uniswap (Constant Product Market Maker)
Balancer (Constant Mean Market Maker)
Curve (Hybrid Function Market Maker)
Impermanent Loss (IL) is one of the most common, yet least understood, sources of risk for any DEX/ AMM liquidity provider (LP). Many LPs are unaware of the fact that they are exposed to price risk, that can wipe out the profits they earned through fees by providing liquidity. The nature of the constant market functions that DEXs use exposes LPs to a negatively convex loss, versus buy & hold, if the entry price differs at all from the exit price. The term "impermanent" is in fact a misnomer, as the loss is very much permanent, unless liquidity is withdrawn at the exact price of entry.
The difficulty with IL is that there is no clean way to hedge it out. Long straddle positions are one way to hedge out some of the exposure, but the linear payout function of vanilla options makes them not highly effective. In addition, limited liquidity and high costs of decentralized option markets provide further barriers to retail investors.
Source: [Pintail](<https://medium.com/@pintail>)
The convexity protocol pioneered by Opyn [1], and the Hegic Protocol [2] are the most notable ERC20 options market protocols. Maker [3] and Compound [4] have made excellent progress in the creation of collateralized on-chain decentralized lending markets, while Synthetix [5] and UMA [6] have laid the foundation for the creation of synthetic asset exposure, and total return swaps. Yield Protocol [7] took these ideas one step further, and pioneered the adoption of reverse dutch auction token sales.