It is meaningless to be judged by Vitalik Buterin. Does ApeCoin have any value?

On March 17, 2022, Yuga Labs, the owner of the Bored Ape Yacht Club (BAYC) brand and related derivatives, launched Ape Coin (APE). Owners of BAYC and BAYC-related NFTs can claim a large amount of ApeCoin for free, and the liquidity of the token has also been added to major exchanges such as FTX. Although ApeCoin is currently not functional, it is a subject of considerable interest to traders, and the NFT market has also become hot.

However, although the emergence of ApeCoin has once again heated up the market in the NFT field, Vitalik Buterin judged in his article in Time Magazine that BAYC's coin issuance is meaningless and a gambling behavior. From the basic data, after the initial plunge after the release of ApeCoin, the token price rose 2.5 times in the following 24 hours, and the fully diluted valuation exceeded 15 billion US dollars. Faced with such price performance, what is the economic model behind ApeCoin, and where does its liquidity come from? Next, this article will reveal to you where the key liquidity source of ApeCoin is.

Source: Github

Author: Doug Colkitt, @0910841082130913312

Compiled by: Chen Yiwanfeng

While the majority of ApeCoin volume occurs on centralized exchanges such as FTX and Binance, a significant portion of volume also occurs on-chain, primarily through Uniswap on the Ethereum mainnet. In this post, we report the results of our initial analysis of the first 24 hours of on-chain trading data, focusing on the profits of liquidity providers. Liquidity providers on Uniswap V3 earn income by charging trading fees (a fixed percentage of all swap volume). However, as prices fluctuate, they also suffer from impermanent loss (IL), a phenomenon in AMMs where pools rebalance in the “wrong” direction relative to price movements. Therefore, whether liquidity providers profit relative to their portfolios holding paired assets directly depends on the balance between trading fees and impermanent loss.

We show that while over 86% of ApeCoin liquidity positions on Uniswap V3 are profitable compared to their initial investment balances, most liquidity positions suffer impermanent losses that exceed their accumulated transaction fees, suggesting that the typical liquidity provider would be better off just holding APE. The results suggest that liquidity providers systematically underestimate the volatility of peCoin prices, causing them to narrow their position ranges and incur large impermanent losses.

Initial observation

After the launch of ApeCoin on centralized exchanges, liquidity was immediately initialized on Uniswap V3, first through the APE/ETH pool and then through the APE/USDC pool about an hour later. The initial price surged and then dropped sharply. After a few hours at around $8 per APE, the price began to rise steadily, reaching a high of over $16 by the end of the first 24 hours:

Aside from some heightened volatility in the first hour of trading (likely due to a severe lack of liquidity), the price of ApeCoin has been remarkably consistent across both the APE/ETH and APE/USDC liquidity pools: this is not surprising, as the default for Uniswap is to route swaps through multiple pools for best execution. Even price dislocations that don’t exceed the swap fee will be brought back by arbitrageurs.

It’s worth noting that both the APE/ETH and APE/USDC liquidity pools on Uniswap charge a 1% fee — higher than typical active pools (e.g., ETH/LOOKS mostly trades at 0.3%), but not unprecedented (SHIB and other meme tokens tend to have 1% fee tiers). Given the strong trading interest in ApeCoin, this is an attractive incentive for users to step in and add liquidity to capture the high trading fees. Accordingly, within the first 12 hours of trading, the number of open liquidity positions on Uniswap soared, eventually stabilizing at around 650:

Interestingly, the vast majority of liquidity positions are generated in the APE/ETH pool, not in the APE/USDC pool. Correspondingly, the APE/ETH pool also contains the majority of liquidity in USD:

On average, the size of liquidity positions in both pools is similar. As shown in the figure below, all liquidity positions are below $10 million. However, the distribution of position sizes is still quite wide, ranging from positions of $100 or less all the way to the top seven figures.

One reason why liquidity providers may prefer APE/ETH is to minimize impermanent loss. In principle, the prices of APE and ETH should be partially correlated with market beta; therefore, ETH is often the currency of choice for volatile, high-risk assets such as ApeCoin. On timeframes as short as 1-2 days, ETH's price volatility is typically quite low, so the APE/ETH and APE/USDC pools should not experience wildly different impermanent losses. Despite this, liquidity providers are clearly more willing to provide liquidity to APE/ETH than APE/USDC.

After a sharp drop in the first 6 hours, ApeCoin’s total Uniswap volume remained fairly high throughout the day:

We can already see immediately that providing ApeCoin liquidity on Uniswap could be a very rewarding endeavor. Observe the chart: Assume we estimate 10-minute volume of $3M, corresponding to fees of $30K. Multiplying by the number of 10-minute periods in a day and dividing by $40M in total liquidity suggests that LPs are seeing returns of around 10% in the first 24 hours (before accounting for impermanent loss). This calculation is borne out by the current Uniswap estimated 24-hour fees of 11% of the TVL in the APE/ETH liquidity pool.

However, fee generation is not the only determinant of liquidity provider profitability!

Impermanent losses and expense generation

To better understand the rewards of providing ApeCoin liquidity, we also need to consider the phenomenon of impermanent loss. Because providing liquidity within a given price range is essentially selling a well-performing asset when it appreciates (equivalent to buying a relatively poorly performing asset when it depreciates), the portfolio of liquidity providers is expected to be strictly lower than the performance of directly holding assets. However, if the transaction fee is set appropriately based on the trading volume and the extent of the expected price movement, liquidity providers may make a profit.

As we have observed before, the price of ApeCoin increased significantly in the first 24 hours of trading. Therefore, the impermanent loss experienced by liquidity providers is expected to be considerable, and it is valuable to understand whether it is really worth it for them to provide liquidity.

To do this, we estimate the impermanent loss generated by each liquidity position. Between minting and burning transactions, the liquidity of each liquidity position can be increased and decreased many times, which means that we have to be very careful to define impermanent loss precisely. For each liquidity position, we tabulate all liquidity addition events and track how many tokens of each type were added. We consider impermanent loss from the time the liquidity position is minted to the time the liquidity position is burned (if it is burned within the first 24 hours after launch) or at the end of the 24 hours.

To define our baseline counterfactual, where liquidity providers keep their tokens in their wallets and never create positions, we consider the following question: For each liquidity addition event, assume that the liquidity provider keeps the same amount of tokens (APE, ETH, and/or USDC) but never mints or adds them to liquidity positions. At the end of the evaluation period, what is the value of their portfolio?

Next, we calculated the exact market value of the liquidity position at the end of the evaluation period, which is determined entirely by market prices, the scope of the liquidity position, and the tokens supplied. Finally, we took the difference between their hypothetical counterfactual portfolio value without liquidity minting and their actual portfolio value at the end of the evaluation period, and divided this difference by the total USD value of the liquidity they provided. This ratio is shown below.

The median liquidity position lost 0.3% of its initial portfolio value due to impermanent loss. However, the distribution of such losses has a long right tail, and on average, positions lost 9.4% of their initial principal to IL. (Of course, they may have gained more from the appreciation of the underlying ApeCoin venture.) In the worst case, some people experienced 100% of their initial principal in IL!

Although it may seem incredible, manually inspecting the top three liquid positions ranked by impermanent loss shows that these numbers are accurate:

#1 (204927) adds liquidity to 1ETH at a price of approximately 150,000x APE's current market price, which is currently down 100% from where it cannot recover.

#2 (205104) Added 1,500 APE liquidity when the APE price was $6.56 with an initial portfolio value of $9,840. At the end of the evaluation period, the position was still open and the APE price was $14.78, close to its range cap; therefore, the position was mostly ETH with a total value of $13,964. In contrast, if the minter had simply kept the 1,500 APE in their wallet, their value would have been $22,170. The difference between the two is that their impermanent loss is $8,206, almost 84% of their initial position value.

#3 (205949) added 50,470 APE of liquidity at an APE price of $7.96. They set a very narrow range for their liquidity position. Specifically, 0.0029 to 0.0031 ETH per APE, which at $2,800 per ETH is approximately $8.12 to $8.68 per APE. At the end of the first 24 hours, their position was still open, with the price of APE well above the upper limit of their range. Essentially, their range operation acted like a limit order, selling APE continuously from $8.12 to $8.68 (roughly a 5% profit from the starting price), so they missed all subsequent price increases of APE (beyond the upper limit of $8.68, their position essentially converted to 100% ETH).

In general, given the steady upward trend in ApeCoin’s price action, the duration that a liquidity position remains open is strongly correlated to the degree of impermanent loss:

While there is considerable variation depending on the exact opening and closing times of liquid positions, as expected we see that keeping liquid positions open longer also leads to larger impermanent losses during strong price movements.

Are accrued transaction fees sufficient to compensate for the severity of impermanent loss? To answer this question, we derive a basic estimate of transaction fees realized by each liquidity position. For each 10-minute interval, we tabulate the liquidity positions that are open and within the interval, as well as the total swap volume in that interval. For simplicity, we estimate that transaction fees (1% of volume) are allocated pro rata to all active liquidity positions in proportion to market value.

As we can see, depending on the size and duration of the position, the trading fees earned can often amount to tens of thousands of dollars. Dividing the fees generated by the initial market value of the liquidity position, we find that the fees collected are, on average, insufficient to fully compensate for the impermanent loss:

The median (respectively the average) position earned 3.3% (respectively 5.7%) of its initial principal in fees. However, a significant portion of positions performed significantly better than these statistics, with 21.9% of liquid positions earning more than 10% of their initial principal in fees. The strongest performer, ID 204926, managed to earn a whopping 33.1% of its initial value in fees.

We can now directly subtract IL from the fees earned to see the likelihood of a liquidity provider making a profit relative to a hypothetical portfolio where they only held APE and ETH/USDC instead of taking a liquidity position:

Therefore, the answer to our incentive question is no - most ApeCoin liquidity positions are not profitable in terms of impermanent loss vs. fees. Because many positions have both zero fees and impermanent loss (perhaps due to being permanently out of range), the middle position ends up exactly breaking even. However, there are a large number of long-tail losses, with the average liquidity position losing 3.8% of its initial principal in this calculation.

Note that this does not mean that most liquidity positions lose money relative to their initial state! Rather, it means that during the first 24 hours of ApeCoin trading on Uniswap V3, the balance of impermanent loss vs. fees tended to favor impermanent loss for most liquidity positions. This can be intuitively thought of as a distribution of returns if liquidity providers are fully hedged (e.g., via perpetual futures on external exchanges; assuming funding fees are negligible).

In practice, we can also examine the total return of a liquid position by adding the portfolio value at the end of the evaluation period (when the position is closed or at the end of the previous 24 hours) to our estimate of accrued expenses divided by the initial portfolio value:

Of the nearly 1,700 liquidity positions studied, 86% of positions were profitable, with the median position achieving a 7.7% return on its initial portfolio and the average position achieving a significant return of 13.5%! Of course, what goes up can also go down, and if the price of ApeCoin goes down instead of up, liquidity providers will lose money significantly. Ultimately, these results suggest that the typical liquidity provider may be better off not providing liquidity, but instead holding ApeCoin directly to profit from its appreciation.

Comparison with environmental mobility

Providing concentrated liquidity in Uniswap V3 has both benefits and risks. If the price remains within a predetermined range, liquidity providers can collect trading fees with greater capital efficiency. However, if the price moves far outside the range of the position, liquidity providers face the prospect of severe impermanent loss on deactivated positions without even collecting any trading fees.

As a point of comparison, it can be illustrated how liquidity would play out via the more classic xy=k model (implemented on Uniswap V2 and still valid in Uniswap V3 by setting a maximum range). This model is much simpler to analyze, with the value of the portfolio scaling proportional to the square root of the risk asset (if we use ETH or USDC as denominated). Assume that liquidity providers are all simply adding ambient, xy=k liquidity, rather than defining narrow, concentrated positions. What would their returns be?

We find that, as shown below, impermanent loss is significantly reduced relative to the IL observed in the actual liquidity position data:

It is worth noting that IL’s worst-case scenario is a loss of only 15% of the initial portfolio value, contrary to our empirical observations of multiple >50% losses on users’ actual positions. Going a step further, subtracting this hypothetical xy = k IL from the fees, it looks like the balance between the two depends largely on profitability:

If all liquidity providers provided ambient liquidity, then fully 95% of positions would profit from the fee balance, and only IL! This result strongly suggests that liquidity providers are not accurately estimating the extent of future price volatility or appreciation, and therefore significantly underestimate the extent of their liquidity positions.

Position out of range

As we saw above, the trading fees collected on liquidity positions are considerable, even if they are not always above the impermanent loss. In order to collect trading fees effectively, liquidity providers must ensure that the range of their concentrated Uniswap V3 positions is wide enough. Otherwise, given ApeCoin’s strong directional price movement during the second half of the time period we studied, their liquidity positions may become invalid as the price exceeds their upper limit. This would be doubly painful as they would miss out on ApeCoin’s price appreciation as well as all trading fees derived from swap volume after their positions become invalid.

By tracking liquidity positions and pool prices over time, we can accurately calculate the proportion of open liquidity positions that were actually in range during the previous 24 hours:

For most of the first 12 hours, over 85% of APE/ETH and APE/USDC liquidity positions were in range. But as ApeCoin price began to rise rapidly, APE/ETH positions dropped to as low as 50% and APE/USDC positions dropped to as low as 30%, indicating that liquidity providers did not anticipate the rapid upward trend and therefore set their positions too narrowly. Overlaying ApeCoin's price over time onto the same graph makes this trend particularly clear (note that ApeCoin's price has been arbitrarily rescaled to fit the same vertical axis):

The plots above reveal an interesting dynamic. Overall, we see that the proportion of range-bound liquidity by volume is generally higher than the proportion of individual unweighted positions that are in range, suggesting that larger liquidity positions are generally more likely to be in range. This phenomenon could be due to a number of different reasons. For example, on the Ethereum mainnet, transaction fees can be quite high; therefore, active management of liquidity positions is more valuable for larger position sizes, as the benefits of staying in range increasingly outweigh the fixed cost of paying gas fees. Additionally, larger liquidity providers may have more sophisticated and active approaches to liquidity management overall, where they continually monitor price movements and rebalance positions as needed, or make more informed forecasts of future price movements in order to set appropriately broad ranges for their liquidity positions.

Liquidity providers naturally don't want their positions to be out of range, so upper and lower limits should be set for newly created liquidity positions to reflect expectations of future price movements. These expectations may change organically over time as new and existing liquidity providers observe the fluctuations in the price of ApeCoin. If we examine the upper limits of newly generated liquidity positions over time, we can see that this is indeed the case:

In particular, we see that as the price of ApeCoin increases in the second half of the 24-hour period, the upper limit of newly created positions is not proportional to the appreciation of ApeCoin (i.e. the upper limit is not always a constant distance from the current ApeCoin price). This suggests that as liquidity providers begin to observe the upward price trend of ApeCoin, they also revise their expectations of future price growth upwards. A similar trend can be observed for the lower limit of newly created positions:

By the end of the first 24 hours, the lowest floor for new liquidity positions had begun to overlap with the actual price of ApeCoin from 18-24 hours ago.

Finally, to explicitly compare the efficiency of the APE/ETH and APE/USDC liquidity pools in collecting trading fees over time, we can take the swap volume of each pool at each point in time and normalize it by the amount of active (in-scope) liquidity available at that point in time. This ratio is plotted below (using a log scale for clarity).

We see that fee accrual in the APE/ETH pool is slightly better than fee accrual in APE/USDC in terms of consistency and the absolute amount of fees collected on average. However, the difference is fairly insignificant, suggesting that the implied market for liquidity provision is keeping the fee-to-TVL ratio relatively similar between the two pools. Note that there are several different factors implicit in this metric: trading volume, the amount of overall liquidity provided, and the fraction of liquidity that is actually provided within the range.

in conclusion

Providing liquidity on Uniswap V3 requires a delicate balancing of many different factors. Liquidity providers must make predictions about future price volatility and direction and set an appropriate range for their concentrated liquidity positions to maximize their capture of trading fees while minimizing their exposure to impermanent loss. If done well, providing liquidity can be a very profitable endeavor; otherwise, it can be risky and, at times, costly.

The benefits of pooled liquidity are enormous: Uniswap V3 allows for arbitrary distribution of liquidity to be replicated across prices, significantly improving capital efficiency and superior swap execution. However, these results highlight the importance of further development in the pooled liquidity DEX space. Future iterations of this model that provide greater guidance to liquidity providers and support active monitoring and management of liquidity positions will lead to the development of a healthy, self-sustaining liquidity provision ecosystem, which is ultimately what is needed for the long-term success of decentralized finance.