CoFiX Hedging Strategy FAQ
Recently I published an article (CoFiX Hedging Strategy) that gives the basic concept of hedging strategy in general and within the context of the CoFiX ecosystem.
Here we take a brief look at some of the frequently asked questions regarding hedging strategies in context of the CoFiX ecosystem.
Q1. How to deal with changes in market maker’s asset structure after market making?
Answer: Since market making process is a process of integrating market maker’s capital into CoFiX capital pool, as long as the ratio between the two is inconsistent, market making will result in changes in the market maker’s share in the capital pool after market making. Market makers can adopt the following strategies to deal with such changes:
A) Market making is based on the proportion of funds in the fund pool. Before and after this market, the capital structure on both sides will not change.
B) Accept the change of the capital structure, and use this status as the reference state.
C) Do not accept the change of the capital structure. After making the market, immediately initiate a hedging transaction.
Q2. How to allocate assets between market-making and hedging?
Answer: Essentially, the allocation of assets are to offset the incremental changes in market maker’s capital structure in CoFiX. Since transactions can be carried out in both directions, the volume of transactions on both sides will not be strictly matched, resulting in an imbalance in proportion of capital. Such imbalance in proportion determines the ratio between market making assets and hedging assets. There is no absolute recommended ratio. In the previous example, the ratio is 1:1, which represents a safer approach but with relatively low capital utilization rate.
The actual ratio depends on the market maker’s expectation of the imbalance. CoFiX has designed a mining balance coefficient to ensure the balance of its capital pool, but this is not an absolute guarantee. If you are pessimistic, you can allocate more assets for hedging. If you are optimistic, you can reduce the amount for hedging.
However, no matter what expectation you hold, when there is an imbalance in proportion of capital, which will lead to exhaustion of a type of hedging assets, actions must be taken, such as stopping market making or re-adjusting asset structure.
Q3. Is it possible to hedge only twice at entry and exit?
Answer: No.
Hedging aims at avoiding risks caused by price fluctuation, which happens all the time. If hedging is done only twice at entry and exit, then during the market making period, assets that are about to appreciate are taken out, while assets that are about to depreciate are added in, so that each transaction will devalue the total assets of CoFiX capital pool.
Of course, the actual situation may be different, and even reversed, but changes in price are unpredictable, because the purpose of hedging is to eliminate risks in price fluctuation and achieve definite profit.
Q4. What should I do if capital for hedging is insufficient?
Answer: Capital for hedging consists of two parts: ETH and USDT.
But usually insufficiency is caused by insufficiency of only one type of capital. This is usually the case because CoFiX is traded in one direction, resulting in one type of hedging capital being replaced by the other kind.
At this time, it may be impossible to continue hedging. In order to avoid the risk in price fluctuation and ensure the safety of funds, it is necessary to immediately stop market making or readjust the allocation of funds.
Q5. Can hedging be performed by initiating a transaction in CoFiX?
Answer: No.
The essence of CoFiX is to allow market makers to gain profit by taking on certain risks in price fluctuation. The basic assumption is that the transaction cost of CoFiX is higher than the cost of over-the-counter transactions. In this way, market traders enjoy higher certainty in profit making through hedging. Therefore hedging should be done externally.
Due to the high transaction cost of CoFiX, if market makers perform hedging by trading in CoFiX, there will be a greater cost of hedging, squeezing profit or even incurring loss.
Q6. Can market making incur loss?
Answer: Possibly.
Market makers obtain profits in the transaction by taking on certain risks in price fluctuation, which can be minimized through hedging. However, some objective factors may still cause market makers to lose money, mainly in two situations:
A) The market maker does not hedge. In this case, the risk of price fluctuations will always affect the market maker, making him or her prone to losses.
B) Hedging is not timely
If hedging is not timely or the price fluctuates too sharply, and the interval between the execution of hedging program is too long, market makers may suffer loss.