Buyers pay regular funding payments to a Writer Pool, and in return receive protection against impermanent loss on their LP positions.
Buyers can perfectly hedge impermanent loss risk from their LP positions if they open NIL contracts with a strike price that matches the price of Token A when they enter their LP position.
Buyers open a NIL contract by paying in the mark-to-market ILV on the contract, the value of which they retain claims to. ILV goes up when the token price moves away from the strike, and vice versa.
If the current price of Token A is exactly the same as the strike price, Buyers pay nothing upfront to open a NIL contract, as impermanent loss and mark-to-market ILV is zero.
Buyers deposit margin into their margin account, which is used to pay continuous funding rate payments to the Writer Pool in exchange for their impermanent loss protection.
Here’s an example of how a Buyer would use NIL to hedge their LP position
- 1.Alice deposits 10 WETH and 10,000 USDC into WETH-USDC on Uniswap V2 as an LP
- The price of WETH at the time of her entering the liquidity pool was 1,000 USDC
- She has 20,000 USDC worth of exposure in her LP position
- 2.Alice wants to hedge out her impermanent loss risk, so she goes to the NIL dapp and looks at the funding rate for the UNIV2-WETH-USDC-1000
- 3.The cost of protection (funding rate premium) looks reasonable to her, so she deposits margin into her account and opens 20 UNIV2-WETH-USDC-1000 NIL contracts to fully cover the IL risk on her LP position
- Because the contract strike price is the same as the current price (ILV = 0), Alice does not actually pay anything upfront for her NIL contracts. Her only payment is through regular funding rate payments deducted out of her margin account
- 4.Funding payments are be deducted from Alice’s margin account each funding period, based on the funding rate and the total amount of NIL contracts she opened
- 5.As the price of WETH/USDC changes over time, the ILV of Alice’s NIL contracts is marked-to-market according to the impermanent loss value formula
- 6.When Alice decides to withdraw her liquidity from the WETH-USDC pool and no longer needs the impermanent loss hedge, she would also close her NIL position
- The ILV payout claimable from her NIL contracts will exactly cover the amount she lost in the liquidity pool due to impermanent loss
In theory, Alice could unwind her NIL position at any time (not necessarily when she withdraws liquidity from Uniswap). But in that case she would be speculating on IL, rather than hedging her LP position.
By opening NIL contracts, Buyers are effectively going long pair-volatility and purchasing impermanent loss protection from the Writer Pool.
AMM LP positions are inherently short pair-volatility, which exposes LPs to impermanent loss. Using NIL, LPs can open NIL contracts to purchase impermanent loss protection from the Writer Pool and perfectly hedge out their impermanent loss risk. This is highly valuable because LPs can collect trading fees and yield farming rewards without needing to worry about realizing any impermanent loss.
In addition to normal profit-seeking LPs, Protocol DAOs who want to provide AMM liquidity for their native tokens can use NIL to hedge IL risk, so they can continue to provide trading liquidity for their community without worrying about taking a big hit on impermanent loss.
In exchange for impermanent loss protection, Buyers pay a dynamic funding rate to Writer Pools.
There is no requirement to actually have AMM LP positions in order to open NIL contracts – a speculative Buyer could choose to use NIL to go long impermanent loss if they believe pair-volatility will be higher in the future.
If a Buyer does not have sufficient margin to cover payment for the next funding period, the protocol will automatically close their NIL contracts and deduct a 2% liquidation penalty on the total value of their NIL contracts.
The liquidation penalty will first be taken from the remaining margin in the Buyer’s account, then from the Buyer’s ILV claimable amount. Any remaining ILV from the Buyer’s contracts is then free to be claimed by the Buyer after the liquidation.