Volatility Farming
Introducing the Concept
Volatility Farming leverages ongoing fluctuations in original and wrapped asset prices through a parallel liquidity approach, with regular users supporting this mechanism. This creates a self-sustaining, closed ecosystem where arbitrage opportunities arise without relying on oracles or price feeds, enabling users to benefit from these opportunities efficiently.
This approach benefits two key user groups:
Arbitrage Participants: Users who profit from price movements between original and derivative assets, leveraging the closed ecosystem to generate yield.
Liquidity Providers: Users who enable arbitrage opportunities by creating & supplying parallel liquidity to the closed ecosystem, collecting competitive and sustainable yields in return for their contribution.
In simple terms, a secondary market for the original liquidity pair is created, allowing participants to profit from price volatility between the original market and the secondary market. This system not only democratizes access to arbitrage opportunities but also ensures sustainable yield generation for all participants involved.
Volatility Farming Key Components
For Volatility Farming to exist, the following key components are required:
Participants: Liquidity providers and arbitrageurs;
Actions: Wrapping assets, providing liquidity, and executing arbitrage;
Instruments: Specialized tools designed for liquidity provision and arbitrage execution.
Key Concepts
Parallel Liquidity Model
How is it created
A cornerstone of the volatility farming ecosystem is the Parallel Liquidity Model, which enables the creation of opportunities for arbitrage and yield generation. Parallel liquidity is established through two key steps:
Wrapping an Asset: At least one asset from the original liquidity pair is wrapped into a derivative token.
Creating a Parallel Liquidity Pair: A new liquidity pool is created using the derivative token and the remaining asset.
Consider this example above. YEL/USDT pair trading on a DEX as the original liquidity pool. YEL is wrapped into its derivative, lYEL. A parallel liquidity pool is then created with lYEL and USDT.
Derivative Assets
Derivative tokens are created through a wrapping process facilitated by the system. This process involves staking original assets (e.g., YEL) and receiving their derivative counterparts (e.g., lYEL).
Key Characteristics of Derivative Tokens:
Liquid: Derivative tokens can be freely traded in secondary markets, in particurarly within parallel liquidity pools, as well as integrated into third-party solutions and utilized there;
Overbacked: Each time a user wraps an original asset into a derivative, the system collects a fee, ensuring the derivative tokens are overbacked, and can be unwraped at any time.
Yield-Generating: By simply holding derivative tokens, users earn yield generated from the fees collected during wrapping and unwrapping.
Price Discrepancies Between Parallel Liquidity Sources
This model allows for price discrepancies to occur because the prices of assets in the parallel pool (e.g., lYEL/USDT) are not directly tied to those in the original pool (e.g., YEL/USDT). As a result, price variances can develop between the original and derivative tokens, creating arbitrage opportunities.
Original markets are influenced by numerous factors that drive their volatility, such as: market demand and supply dynamics, external market sentiment, price movements across numerous venues (CEXs, DEXs, cross-chain), trading volumes and liquidity imbalances. In contrast, derivative markets are purely dependent on user actions within the ecosystem, such as: wrapping or unwrapping of assets, liquidity provisioning within parallel pools, arbitrage execution by participants. This distinction ensures that price discrepancies naturally occur between the original and parallel markets, providing continuous arbitrage opportunities for participants.
In the example above, we observe two scenarios: one where the price of YEL is higher than its derivative, lYEL, and vice versa. Both scenarios present opportunities for arbitrage.
The process involves buying the original or derivative token, wrapping or unwrapping it, and selling it in the parallel liquidity pool to profit from the price difference.
Fees & Incentivization Model to Drive Volatility
To drive volatility and sustain yield generation within the ecosystem, a fee model has been integrated into the concept of volatility farming. This serves two primary purposes: (i) maximizing volatility within the ecosystem to create more arbitrage opportunities; and (ii) incentivizing users to provide liquidity and support the ecosystem.
Basically, fees can be separated into 2 categories:
Volatility Fees: designed to manually drive volatility by encouraging asset movement. These fees are applied to actions that stimulate price variances, creating additional arbitrage opportunities.
Ecosystem Fees: aimed at incentivizing participants to support the ecosystem.
Fees can be applied to the following actions within the ecosystem:
Wrap and Unwrap Derivative Assets: Fees are charged when converting original assets into derivatives or back to their original form.
Buy/Sell Derivative Assets: Transaction fees apply to trades involving derivative assets within the ecosystem to stimulate activity and liquidity flow.
Additional Fees: Optional fees may be introduced to:
Support ecosystem growth initiatives.
Motivate users to create and sustain derivative markets within the ecosystem.
Breakdown of all potential fees within the volatility farming ecosystem:
Wrap Fees
When user wraps original asset (e.g. YEL) into derivative (e.g. lYEL)
Drive volatility;
Yield generation for derivative token holders (Holder APR) & liquidity providers (LP APR).
UnWrap Fees
When user unwraps derivative asset (e.g. lYEL) into original (e.g. YEL)
Drive volatility;
Yield generation for derivative token holders (Holder APR)
Buy/Sell Fee
Purchasing/selling a derivative asset (e.g. lYEl)
Drive volatility;
Yield generation for liquidity providers (LP APR).
Burn Fee
When user wraps/unwraps an asset; Purchasing/selling a derivative asset
Drive volatility;
Support Ecosystem's Tokenomics.
Partner Fee
When user wraps/unwraps an asset
Incentivise users to create derivative assets & parallel liquidity pools.
Admin Fee
When user wraps/unwraps an asset
Ecosystem's sustainability;
Support Ecosystem's Tokenomics.
Fees play a key role in ensuring the long-term sustainability and growth of the volatility farming ecosystem.
Liquidity Providers are rewarded for providing liquidity in two ways:
They earn the standard trading fee from the DEX where the liquidity pair is located.
They receive additional APR from the ecosystem’s fee model, which can enhances their original APR.
The system creates a sustainable “fee loop” that keeps the ecosystem active when users execute arbitrage, they pay fees for wrapping, unwrapping, or trading derivative assets. These fees flow back into the system and are used to reward liquidity providers.
This setup ensures that fees not only support liquidity providers but also help the entire ecosystem grow by driving continuous activity and creating more opportunities for all participants.
Volatility Participants & Game Theory
For volatility farming to function, the following types of participants are required:
Staker
Wrapping assets to create and hold derivatives, creating price discrepancies
Collecting Holder APR
Liquidity Provider
Providing parallel liquidity in a form of wrapped asset and original asset/wrapped asset to enable trading and arbitrage within the ecosystem
Collecting LP APR
Arbitrageur
Identifying and capitalizing on price discrepancies between original and wrapped assets
Collecting Arbitrage Revenues
The active participation and involvement of each participant type are guided by game theory, which ensures that the system operates efficiently and sustainably. Each user type plays a crucial role in maintaining the balance of the ecosystem. Without one type of participant, the system cannot function effectively, and all roles benefit only when they work together.
Game theory also prescribes a balanced distribution of participants among the roles. When one strategy (e.g., arbitrage) becomes overwhelmingly dominant over others, the system’s efficiency diminishes. In such cases, participants in the dominant strategy are naturally incentivized to switch to other roles, such as providing liquidity or wrapping assets, to maximize their benefits.
This dynamic ensures that the ecosystem remains self-regulating and balanced, allowing all participants to benefit from their contributions while maintaining the system's overall efficiency and stability.
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