Volatility Farming

Details about our upcoming volatility farming feature

Amendment 1: Current Limitations of Volatility Farming and Potential Approaches

Volatility farming, also known as arbitrage in cryptocurrency markets, has a storied history. Notably, figures like Sam Bankman-Fried (SBF) gained fame by capitalizing on price discrepancies across various exchanges. With time, automated arbitrage systems have evolved, transforming this practice into one of the most lucrative and low-risk financial strategies. In this domain, it's often the intermediaries - exchanges and brokers - that reap significant benefits through trading fees.

In the realm of decentralized finance (DeFi), volatility farming has taken on a new dimension. The introduction of a dual-token system, comprising $BTC and $aBTC, along with substantial conversion fees (ranging from 1-3%), has created an environment ripe for arbitrage. This involves a straightforward process of swapping between two distinct liquidity pools, allowing the protocol to either redistribute collected fees to liquidity providers or to diminish circulating supply through token burning. This innovative approach has proven profitable, thriving in the notoriously volatile crypto market.

Challenges and Proposed Solutions

1. Diverse Arbitrage Paths:

Beyond the primary exchange mechanism between $BTC and $aBTC, alternative arbitrage routes exist. For instance, utilizing a dense liquidity pool in Uniswap V3 for $BTC-$aBTC trades bypasses the hefty 1-3% minting/redeeming fees. Consequently, this deprives the protocol of potential fee revenue. Despite lucrative yields for users contributing to this Uniswap V3 LP pool, it's in the protocol's interest to channel these yields back into the system to better regulate token burning and reward distribution.

Proposed solution:

Develop a framework that centralizes arbitrage transactions through a single channel, ensuring that the protocol directly benefits from the swapping fees between $BTC and $aBTC.

2. Initial Bootstrapping and Long-Term Incentives:

The yield primarily originates from arbitrage, which is negligible at the outset. This lack of initial yield deters users from exchanging their principal tokens ($BTC for $aBTC), given the high fees and risks associated with Impermanent Loss in Liquidity Providing. This necessitates substantial liquidity support from the protocol, investors, or market makers to kickstart the arbitrage cycle. Additionally, an over-reliance on fee-based rewards may hinder long-term growth, particularly in less volatile markets, leading to a diminishing liquidity spiral.

Proposed solution:

Implement an initial reward system based on token emissions to stimulate arbitrage activities. The influx from arbitrage and minting fees should ideally offset the inflationary impact of these rewards. Further, dynamically adjust emissions to maintain a healthy inflation rate. This approach aims to optimize profits from fees during volatile periods (potentially outpacing emissions) and sustain user engagement during less volatile times through ongoing emissions. This strategy not only ensures consistent rewards for users but also helps the protocol maintain substantial liquidity reserves, preparing it for periods of high volatility.

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