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There are massive opportunities for earning fees if an LP can figure out how to successfully manage a concentrated liquidity position.
Here’s some good news for anyone hiding in stablecoins until the next bull run. Kamino Finance, a product incubated by the crypto-backed stablecoin project Hubble Protocol, has claimed that its USDC-USDT concentrated liquidity strategy could possibly deliver 4% APY in a month during its preliminary testing.
If Kamino’s data are correct, the decentralized finance (DeFi) protocol has found a way to squeeze massive value out of assets with minimal directional exposure to the bear market. This article will investigate how a four percent return in one month could be possible.
What Is Concentrated Liquidity?
The concentrated liquidity market maker (CLMM) significantly improves the technology behind decentralized exchanges (DEXs). Compared with the traditional automated market maker (AMM), which has powered most DEXs since 2018, CLMMs are potentially 4,000x (400,000%) more capital efficient.
The way AMMs are programmed, around 99% of the stablecoins provided as liquidity will never be used to facilitate trades. This inefficiency is due to the fact the AMM formula, x*y=k, will spread liquidity evenly across a price curve that ranges from zero to infinity.
CLMMs increase the capital efficiency of DEXs by supplying liquidity at realistic price points, which could fall between $0.999 and $1.001 for stablecoins. Users can choose wide or extremely narrow price ranges for providing liquidity, and the more narrow the range one set around a current price, the more one’s tokens will be used for trade.
Liquidity providers (LPs) have the opportunity to earn more fees with fewer tokens. What’s more, since concentrated liquidity supplies a depth of tokens at current price points, swapping a large number of tokens no longer necessarily leads to price impacts, even for stablecoins.
Why Are Users Avoiding CLMMs?
Nearly every user that swaps tokens through a liquidity aggregator has interacted with a CLMM, whether they know it or not. Liquidity aggregators find the most capital-efficient routes for executing trades, and CLMMs usually attract more volume because of this.
Despite this fact, if you ask most DeFi users to tell you what’s a CLMM, they probably won’t know. CLMMs have been around for over a year and a half, but most users only interact with concentrated liquidity as traders, and few users have stepped up to the challenge of providing CLMMs with liquidity.
The problem with CLMMs is that their capital efficiency comes at the cost of user-friendliness. CLMMs let LPs choose a price range for supplying their tokens, but if the price of a token slide outside this range, then LPs stop earning fees, and they experience extreme impermanent loss (IL).
Providing concentrated liquidity demands consistent management and market-making skills in order to profit from a position, and most DeFi users are not gifted market makers. More than half of users who provide CLMM liquidity have not earned a profit at all from their endeavors.
With fewer users providing liquidity, fewer LPs are splitting fees, which are a form of real yield generated by trading activity. So, there are massive opportunities for earning fees if an LP can figure out how to successfully manage a concentrated liquidity position.
How Could Kamino Hit 4% Monthly on Stablecoins?
Kamino is a yield aggregator that is built on CLMMs instead of AMMs. The vaults on Kamino automate the process of managing liquidity positions on a CLMM, and Kamino’s active management strategies concentrate the fees Kamino collects for its users.
By harnessing the power of Solana’s speed and cost per transaction, Kamino can effectively rebalance positions within a tight range to capture more fees than wider, less efficient positions. On top of rebalancing, Kamino automatically compounds fees back into positions to create deeper liquidity and more chances to earn yield from fees.
Additionally, concentrated liquidity positions are super capital efficient. The leverage from providing stablecoin liquidity on Orca’s Whirlpools can reach as high as 40,002.49x if a position’s range is concentrated as narrowly as possible.
On the other hand, a position with a range set as tightly as possible needs to be rebalanced every time the price of stablecoin moves by as little as $0.001. Ranges can be set wider to remain in the supply sweet spot and incur less IL, but fewer fees are captured as liquidity is less concentrated.
Kamino takes advantage of advanced quantitative modeling to determine what ranges to set and when to rebalance positions to stay within range. Kamino’s process optimizes the way CLMM liquidity is deployed, and this translates into optimized returns from fees.
Can Kamino Sustain Huge Yields Long-Term?
It appears like Kamino’s massive returns from providing concentrated liquidity for the two biggest stablecoins in crypto is, in part, due to the fact that so few users are participating as LPs. This begs the question: Can Kamino continue to deliver such high returns as it makes it easier for users to provide concentrated liquidity?
The answer to this question might lie in the flywheel effect. The combination of CLMM capital efficiency, Kamino’s active management strategies, and liquidity aggregators that automatically port users’ trades through the most capital-efficient routes could potentially create a “perfect storm” for DEX trades on Solana.
As trades routed through Kamino managed liquidity pairs increase due to their increase in capital efficiency, the fees captured by Kamino will also increase. The DeFi community is constantly on the lookout for ways to increase capital efficiency and user participation, and Kamino looks like it has found a niche for increasing both in droves.
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