The Good, the Bad, and the Ugly: Market Making with Kamino

Note: This article is not financial advice. Kamino Finance does not endorse any of the assets or platforms mentioned in this article.

Overview

• Kamino provides utility for market makers providing concentrated liquidity.
• Certain market conditions may fit/not fit certain market conditions.
• Market making bears inherent risks, and users are responsible for their market-making activities.  

Kamino Finance provides a utility that helps users provide concentrated liquidity in an automated and optimized way. Each Kamino vault is designed to reduce the barriers to entry for market making, but they are not designed to change the state of the market and ensure positions are "up-only."

The Good: Market-Making Yield in High Volume

Under certain conditions, Kamino vaults can enhance the UX for liquidity providers while they earn significant yield from fees paid during periods of high trading volume. Kamino vaults are a toolbox full of different utilities, and in the same way that a hammer isn't the best tool for every job, each Kamino vault's performance depends on more than a displayed APY.

At the beginning of January, the launch of BONK spurred a massive amount of trade volume on Solana. The BONK vaults managed to capture a daily APY worth of fees that the protocol hasn't seen before. It was an especially active time for trading on the market with especially high APYs.

That being said, there are inherent risks involved with participating in DeFi, especially when providing liquidity and market making with crypto assets. This article will explain a few of those risks with lists of examples citing multiple situations where users' positions can underperform.  

The Two Main Risks for Market Makers

If users provide liquidity through Kamino Finance's vaults, then it's possible that they incur a loss when participating in the market for several reasons. The two most common reasons why a position's value can be negatively affected are a drop or divergence in price.

An Asset or Both Assets Drop in Value

While users are market making with an asset, they're exposing their position to the price action of that asset. If an asset market makers provide as liquidity drops in value, then their position also drops in value, no matter how much yield from fees has been added to the position.

If users unwind their position while the asset they're providing is down, then they realize the loss. Otherwise, it's possible to wait for the asset to return to a price similar to its entry point while collecting fees, but in the meantime, capital could have been better deployed elsewhere.

Impermanent Loss When Assets Diverge in Value

Impermanent loss is something that can occur when providing liquidity on a DEX. The gist of impermanent loss is that users end up with a growing position in tokens losing value while decreasing their position in tokens gaining value as these assets diverge in price.  

For example, if users are providing liquidity for two different assets, like BONK and SOL, they can end up with more BONK and less SOL if the price of BONK decreases while SOL increases. Liquidity providers are always trading, always in the market, and liquidity takers are always willing to scoop cheap SOL as its price rises in exchange for BONK as its price levels off or decreases.

It's possible to wait for both assets to reach a similar value as their entry point while collecting fees. However, if users unwind their position before this happens, they realize a permanent loss, and if fees collected do not add up to more than the difference made by impermanent loss, then users can end up in the red.  

Kamino will automatically rebalance positions at an optimal time, but it cannot negate impermanent loss, especially if one asset moons. Holding an asset while it moons can be more valuable than providing liquidity for it, since the value of a mooning asset can outweigh the value of the fees earned for trading it, and trading it means market makers end up with fewer tokens on the rise, as they rise.

Assessing Risks for Different Vault Types with Examples

In addition to price exposure, there are several different ways users can incur losses while providing liquidity on Kamino. The following examples will include the most common reasons why a position could lose value as well as a few edge cases that are less common but still possible.

There is a non-zero chance that a vault can be exploited by bad actors. Since this edge case is possible for each pair, it will not be provided as an example.

USDT-USDC (Two Stablecoins)

• Specific to this pair, due to their centralized issuance, both USDT and USDC can be frozen remotely by their issuing companies, Tether and Circle. Arbitrageurs will trade out "bad" stablecoins for "good" stablecoins.
• If one stablecoin de-pegs and loses value, then the liquidity position will fill up with that stablecoin. Users can realize a loss by removing liquidity and exiting their position before the stablecoin regains its peg.
• US Dollar inflation can outpace yield from providing liquidity, reducing the value of capital held in dollar-denominated assets.

SOL-stSOL (Correlated Pairs)

• If stSOL de-pegs from SOL, then the position will become stSOL heavy, and users can realize a loss by removing liquidity and exiting their position before stSOL regains its peg.
• If SOL drops in value, stSOL also drops in value, reducing the value of the liquidity position.
• Since the value of stSOL adjusts to reflect rewards from staking, it will diverge from SOL over time. This decreases exposure to stSOL and increases exposure to SOL in the pool, reducing the amount of yield-bearing assets in the position.

SOL-USDC (Volatile Asset Paired with Stablecoin)

• If SOL drops in value, then the position drops in value while accumulating SOL. If the position falls out of range, SOL will be swapped for USDC to rebalance the position, realizing a loss.
• If SOL increases in value, then the position becomes more USDC-heavy while trading out SOL, and the position does not participate 100% in SOL price discovery. If the position rises out of range, USDC will be swapped for SOL to rebalance the position, making an impermanent loss a realized loss.
• If Circle freezes USDC, then only SOL can be withdrawn from the pool, and arbitrageurs can drain the pool of SOL.

BONK-SOL (Two Volatile Assets)

• If BONK drops in value compared to SOL, then the position drops in value while accumulating BONK. If the position falls out of range, BONK will be swapped for SOL to rebalance the position, realizing a loss.
• If SOL drops in value compared to BONK, then the position drops in value while accumulating SOL. If the position falls out of range, SOL will be swapped for BONK to rebalance the position, realizing a loss.
• If BONK increases in value compared to SOL, then the position becomes more SOL-heavy while trading out BONK, and the position does not participate 100% in BONK price discovery. If the position rises out of range, SOL will be swapped for BONK to rebalance the position, making an impermanent loss a realized loss.
• If SOL increases in value compared to BONK, then the position becomes more BONK-heavy while trading out SOL, and the position does not participate 100% in SOL price discovery. If the position rises out of range, BONK will be swapped for SOL to rebalance the position, making an impermanent loss a realized loss.
• If BONK and SOL both drop in value, then the value of the liquidity position also drops in value.

How Can Market Makers Use Kamino?

Kamino Finance provides a utility for market makers who want to capitalize on their view of the market. Kamino's vaults can be utilized to provide concentrated liquidity for multiple types of assets on a DEX to earn yield from trading fees, but the overall success of any position ultimately depends on each market maker's time in the market.

As this article has explained, market making during volatility can produce negative results if fees collected from volume do not exceed changes in positions due to exposure to the market. There are multiple factors market makers must take into account when participating, and users should proceed with caution if they are unfamiliar with market making or providing concentrated liquidity.

That being said, Kamino vaults can ease the barriers to entry for any user interested in earning yield from market making with their tokens. Kamino offers several different vaults featuring different pairs of assets, and each vault can serve its own time and place within the strategy of conscientious users participating in DeFi.

Additional Resources

• Market Maker Mentality: Which Kamino Vaults are Best for You?
• Case Study: How BONK Vaults Earned Over 999% APY
• What is Market Making?