Lyra’s risk management process is at the heart of its mechanism. It allows the system to competitively price options whilst providing deep, long term liquidity. Risk hedging techniques are used extensively in traditional finance and for good reason - without them, market makers don't last. This article will provide a high level overview of the risks Lyra tracks and hedges for LPs in v1.
Delta describes the risk associated with changes in the price of the underlying asset. We can get a sense for the delta risk of an options position by examining whether we are happy or sad if the price of the asset we’re trading options on increases:
A market maker can accrue a sizable delta position over time, spanning different options and expiries. We calculate Lyra’s overall delta risk by summing Lyra’s exposure for each listed option. This net delta risk represents the number of units of the underlying asset the AMM is long or short. For example, if the AMM is net short 100 ETH deltas, it must purchase 100 ETH in order to be delta neutral.
The delta of an AMM can become very large, very quickly. This is especially true when the options flow is correlated (a phenomenon often observed in crypto markets). DeFi traders tend to be bullish on crypto, so a lack of delta hedging results in LPs repeatedly betting against prices rising. A bet which:
- Hasn’t really worked out well so far
- Even if it were to work out over the long term (we’re skeptical), would still result in large losses/potentially catastrophic drawdowns from price spikes that could irreparably harm LPs
As we said in the launch article:
By delta hedging, we translate each trade into a direct bet on volatility, allowing the AMM to reduce its risk by a dimension. Smoothing delta risk increases alpha and improves the Sharpe ratio of the AMM. In a virtuous cycle, increased alpha leads to more liquidity, driving more volume and yielding more fees.
Vega risk describes the risk associated with changes in the implied volatility (IV) of the underlying asset. We can get a sense for the vega risk of an options position by examining whether we are happy or sad if IV increases.
An AMM accrues a vega position by either net buying or selling a large magnitude of options. Lyra supports both buying and selling options, and its volatility impact mechanism ensures that the number of buyers and sellers quickly converges to an equilibrium level.
Lyra also charges an additional fee for trades which increase the vega risk of the pool. This fee is proportional to the magnitude of the AMM’s current risk (i.e. it gets bigger as the pool takes on more risk). This fee creates an asymmetric spread akin to traditional markets, where the MM incentivizes trades which hedge the risk of the pool, and charges sufficient premium for those that do not.
Lyra calculates and hedges risk for LPs, allowing the AMM to trade options at competitive prices whilst preserving the long term prosperity of LPs. Be under no misconceptions, though. Delta and vega management mechanisms are a great start on the path to managing risk, but are by no means exhaustive. The Lyra AMM is a marked improvement to what's available on-chain, but does not leave LPs fully hedged. Options are risky instruments, so always be sure to only LP what you can afford to lose. We hope this article has helped shed some light on why we place so much importance on hedging. If you have questions, please hit us up in Discord, or check out our docs here.