How to keep calm and invest during a crypto bear market [Vol III]
By David Kuang, Mehdi Lebbar, and Oscar Rivera
Published Dec 22, 2022
Financial markets are in a state of flux today as many investors are experiencing a new Fed regime for the first time in their careers. The stock market saw significant volatility in 2022, with prices fluctuating rapidly in response to changing economic conditions around inflation and interest rates. The collapse of major centralized institutions in the crypto space, such as FTX, BlockFi, and Celsius, has sparked mass sell-offs and exchange withdrawals by spooked retail investors. Does that mean high yields during bear markets are reserved for full-on degens? Not necessarily. At Exponential, our vision is to build an ecosystem of expert research, codified risk assessment tools, and easy investing products that make DeFi truly accessible to everyone. We believe that with the right products, investors of all levels can make informed, confident DeFi investing decisions.
In volume I, we focused on the importance of managing your emotions and sticking to a plan; in volume II, we discussed intermediate passive and active investment strategies and evaluating the incremental risk that comes with them. For the final installment of our bear market series, we will be discussing the most advanced DeFi investment strategies. These strategies come with a higher level of risk and complexity, but we will break them down into clear and easy-to-understand steps in order to demystify DeFi.

Advanced passive strategies

We previously discussed what GMX is and how you can earn a proportional share of fee revenue by holding GLP. To take it a step further, we are now introducing several new delta neutral strategies that are built on top of GLP. In the case of GLP, this means users would purely earn ETH yield as their exposure to the volatility of the underlying directional assets would be mitigated or minimized through other strategies.
A delta neutral strategy is an investment approach that aims to have no directional exposure to the markets. This is achieved by utilizing multiple positions with offsetting positive and negative positions such that the overall portfolio has a delta of zero.
There are a few protocols currently developing their own GLP delta neutral strategies:
  • Rage Trade: Rage Trade is a perpetual swap protocol that recently launched its new Delta Neutral vaults built on top of GLP. These vaults turn GLP’s yield into a stable APR by hedging the exposure of the directional assets (i.e. ETH and BTC) and cater to two types of users: Risk-On and Risk-Off.
The Risk-On vault is long GLP while shorting ETH and BTC exposure to earn delta neutral yield. The vault first takes a flash loan from Balancer in ETH and BTC and sells for USDC on Uniswap. Within the same block, the USDC received is deposited in Aave, along with extra USDC from the Risk-Off vault (maintain a Health Factor of 1.5), to ensure the position has sufficient collateral to prevent liquidations. Using the USDC as collateral, the vault then borrows ETH and BTC to repay the original Balancer loan, effectively shorting ETH and BTC as a result. Lastly, the vault provides an additional boost in yield by auto-compounding the ETH rewards into GLP and staking earned esGMX.
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The Risk-Off vault is a low-risk USDC lending vault. It earns interest from USDC supplied on Aave, as well as a fraction of ETH rewards from GLP based on the amount of USDC lent to the Risk-On vault. The Risk-Off vault lends USDC to the Risk-On vault, which then uses the USDC to short the ETH and BTC exposure in GLP. It also earns leveraged yield since the interest is accrued on the entire USDC position deposited in Aave as collateral for the Risk-On vault’s short position. To further boost yield, a fraction of the ETH yield earned from GLP is also distributed to the Risk-Off vault based on its utilization ratio.
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  • Umami: Umami is a protocol that uses a delta neutral strategy to earn yield from GLP while hedging the underlying asset exposure through third-party platforms.
    • The USDC V1 vault went live in July as one of the first pools aimed to generate a delta neutral return on GLP yield. Users deposited USDC into the Umami vault and received a yield-bearing token, glpUSDC, in return. Using the deposited USDC, the vault mints GLP & Mycelium’s 3x leveraged BTC and ETH hedging derivatives. However, despite earning substantial yield, the V1 vault generated a net loss during its operating period and was ultimately shut down by the team.
    • The team is currently actively developing USDC V2 vaults that will address several of the limitations of the original V1 vault. V2 vaults will feature isolated vaults for each asset in the GLP liquidity pool instead of its prior use of a singular USDC vault. The upcoming product suite will have five vaults that pay yield on USDC, WBTC, ETH, LINK and UNI. These vaults will independently track its underlying asset at a 1:1 ratio (e.g., 1 share of the ETH vault will track 1:1 with the price movement of ETH). Umami’s vaults will use a new hedging strategy that passes GLP's yield onto depositors while hedging out unwanted market delta.
      • Umami’s whitepaper states:
        A crucial element of Umami’s hedging strategy is internal netting. Each of its Vaults acts as a hedging counterparty to the others. Instead of costly external hedges, Umami’s Vaults swap delta among themselves while keeping the vast majority of their TVL deployed to GLP to generate yield. When required, Umami’s Vaults take external long or short hedging positions on GMX or similar exchanges. Umami’s modeling shows that GMX’s leveraged perpetuals are an exceedingly cost effective tool for hedging out unwanted delta for its Vaults.
        The initial backtest results (from Jan-Aug 2022) indicated that the new V2 vault would have generated nearly 27% APR! Expect more details from Umami ahead of the launch of V2 vaults.
While this all sounds great in theory, in practice it is still to be determined if these strategies are sustainable over the long term. This is why protocols conduct substantial backtesting with historical data to try to poke holes in their strategies. Even then, they are not perfect (as we saw with Umami’s V1 vault) and there are additional risks to consider including greater smart contract risks (due to hedging strategies via third-party platforms), GLP-based risks (trader’s profit and losses from GLP pool), and volatility risks.

Advanced active strategies

One of the most intriguing investment opportunities in DeFi today is Chicken Bonds (CBs), which leverage game theory to amplify yield for risk-takers. In fact, this strategy is featured in our #InnovationFrontier section given its complexity and novel approach to bonding in DeFi.
Bonding is a mechanism popularized by Olympus that enables protocols to take ownership of their own liquidity. Instead of incentivizing mercenary liquidity, protocols purchase liquidity from users in exchange for discounts on their own native tokens.
CBs are developed by Liquity with the first use case designed for its own stablecoin, LUSD , and built on top of the protocol’s own Stability Pool. The purpose of the CB is to allow users to earn a greater yield than the LUSD Stability Pool, which serves as an insurance pool for the protocol to handle liquidations during volatile market conditions. LUSD holders deposit into this pool to earn discounts on ETH liquidations and LQTY token incentives. With CBs, a user can decide to bond their LUSD for boosted LUSD (bLUSD), a derivative token that earns an amplified yield through auto-compounding. However, instead of receiving bLUSD immediately, users receive a dynamic NFT (non-fungible token) instead that represents their claim on bLUSD.
So where does this amplified yield come from?
CBs have no maturity, so at any time, users always have two choices:
  • Chicken In: user claims the accrued bLUSD and forfeits their initial LUSD deposit
  • Or, Chicken Out: user reclaims their initial LUSD and forfeits their accrued bLUSD yield
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The Chicken Out function serves to protect users who need their LUSD back for any reason. But by forfeiting their yield, the yield for the remaining bLUSD holders increases as a result. On the other hand, users who Chicken In forgo their LUSD and claim the accrued bLUSD. This yield is designed to taper off over time, with the break-even point expected roughly 15 days post-bond and the optimal time about 30 days.
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The protocol manages bonded LUSD through three internal buckets:
  • Pending: holds LUSD from all open bonds (e.g. no bLUSD claimed)
  • Reserve: holds a portion of LUSD from Chicken Ins and backs the current circulating bLUSD supply
  • Permanent: holds excess LUSD from users who Chicken In early and is fully owned by Liquity
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When a user decides to Chicken In, their LUSD is internally split between the Reserve and Permanent buckets. Earlier Chicken Ins mean the user claims less bLUSD and diverts more LUSD to the Permanent bucket. This serves to increase the future yield flowing from Permanent to Reserve, thus raising bLUSD yield. Those that Chicken In late (after the optimal time) earn bLUSD at a slower rate, which allows the protocol to earn yield longer as users effectively ‘donate’ their yield to the system. The net effect here is a transfer of value from late Chicken Ins to users who timed it more optimally.
As you can quickly see, there are multiple strategies and ways that users can play this out. The main risks that users need to be aware of with CBs are smart contract composability risks, potential withdrawal delays, losses from liquidations, and price risk (bLUSD exchange rate based on Curve).
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Alpha leak: A recent influx of Chicken Ins (represented by the green circles) has resulted in the Curve bLUSD-LUSD3Crv pool yielding over 40% APR paid in LUSD! This is because 3% of all Chicken Ins are allocated to this pool as an ongoing incentive for users to provide liquidity. Remember to monitor large CB positions and the bLUSD price to determine the appropriate time to enter and exit this pool.

Key takeaways

It’s always important to stay true to your personal risk tolerance and time horizon when making investment decisions – regardless of market conditions. You can do this by making a plan and sticking to it (no matter what), striking the right balance of risk-reward, and being aware of the potential for extreme price volatility in crypto. In a bear market, it is important to carefully consider the level of risk you are willing to take on and to have a long-term perspective, as it can be easy to get caught up in the emotional ups and downs of the crypto rollercoaster. Finally, be proactive with your portfolio and stay informed on any fundamental changes that may impact your investment thesis.
That concludes our bear market series. Remember – keep calm and #DegenResponsibly.

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