Tracer’s Perpetual Pools V2 SimulationsExpected Reduction in Volatility Decay
Tracer DAO is coming up on it’s long awaited V2 launch and is ready to present the evolution of the Perpetual Pools product. Part of the V2 offering is the ability to hold leveraged tokens without getting “rekt” by volatility decay. Tracer achieves this feat using a simple moving average (SMA) pricing model. Here’s a preview of the new token performance under this model, arrived at through extensive simulation of the mechanism in thousands of different market conditions.
- Before Tracer, you couldn’t hold a constant leverage position for very long without losing a chunk of it by ‘buying high’ and ‘selling low’ during periods of market volatility.
- We’ve solved this problem with our new SMA pricing function, which uses an optimal 8 hour lag period to smooth daily volatility.
- In V2, thanks to this new pricing function, you can now get a leverage token that doesn’t leak value. Get constant leveraged exposure to any asset long-term with Perpetual Pools V2!
The current problem that leveraged tokens (and leveraged exchanged traded funds) face is that they suffer from volatility decay. Volatility decay describes the under-performance of rebalancing leveraged products when the price of the underlying mean-reverts. It’s a function of the fund effectively ‘buying high’ and ‘selling low’.
Volatility Decay is the Skew Farmer’s Profits
In Tracer’s Perpetual Pools, the volatility decay experienced by the leveraged tokens is caused by skew farming (akin to basis farming in perpetual swap markets). In other words, volatility decay is the skew farmer’s profits. Pool tokens would not experience volatility decay if skew farming didn’t occur. However, if the skew is left unfarmed, the price of the tokens won't track the performance of the underlying asset. You can learn more about skew farming Perpetual Pools here.
Because we want Pool tokens to track the underlying as well as resist decay, the goal is to eliminate as much realised volatility as possible. Our analysis shows that a simple moving average (SMA) lag period smooths volatility in the underlying price movement but still gives the Pools exposure to market trends. Pool tokens perform best in trending markets (markets with directional momentum), so SMA pricing is desirable as it reduces volatility decay when markets are sideways.
To quantify the presence of volatility decay in a perpetual pool that tracks an SMA price, we ran a number of simulations.
Expected Reduction in Volatility Decay
Specifically, we ran 1,000 different year-long price pathways for SMA periods ranging from 1 to 30 hours (e.g. 15 on the x-axis indicates a 15 hour SMA), where all pathways start and end at the same price. This results in 30,000 simulations per leverage.
Then, we logged the vol. decay for each SMA period using the 10 feeds that produced the most decay, and took the average of the ten for each. The results are graphed below (where the blue line is the average, mapped against the range).
Simulations done with 3p leveraged Pool.
We can see the following things:
a) For a single period SMA (1 hour, i.e. the spot price), the volatility decay suffered by the tokens is ~30% for the year. However, the range is wide (50% to 12%).
b) The inclusion of more SMA lag periods reduces the average. By a lag period of 8, the average of the 10 worst volatility decay scenarios is a 5.5% decrease in token value over the year.
c) Decay reduction tapers off over time, indicating that the marginal increase in SMA lag periods has diminishing returns.
An 8-hour SMA
The simulations show that using an 8 hour SMA price feed smoothes realised volatility (intra-day volatility) while retaining medium-long term tracking. Any period greater than 8 hours has only marginal benefits above its impact on the function of the Pools mechanism. By this, we mean that minting and burning windows must increase to prevent the exploitation of the new pricing, and periods greater than 8 hours both impact the retail experience and skew farming strategies.
All things considered, we have chosen an 8 hour period for SMA pricing – to be used by Perpetual Pools V2 for improved leveraged token performance. However, this new pricing function doesn't prevent vol. decay completely.
Mint Fee Addresses Remaining Volatility Decay
We have seen that, on average (under worst-case assumptions), tokens still lose 5.5% of their value to skew farmers. This is fine – skew farmers are needed to keep tokens tracking leveraged returns on the underlying. To compensate for this remaining 5.5% decay, new entrants will need to pay a 1% mint fee on 3p Pools because they are the ones that dilute the gains of existing traders. All mint fees are directed back into the pools to help offset the remaining impact of volatility decay.
To learn more about Tracer’s Perpetual Pools V2, read our latest explainer: https://tracer.finance/radar/perpetual-pools-v2-roadmap/
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Disclaimer: Simulated market conditions may be unlike real market conditions. The results of these simulations are indicative only and do not guarantee the performance of Perpetual Pools V2.