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Liquidity Rebalancing

December 7, 2023

Liquidity Rebalancing

Liquidity plays a crucial role in the crypto industry for several reasons. Firstly, it ensures traders can easily buy and sell assets without experiencing significant price slippage. Secondly, liquidity is essential for properly functioning lending and borrowing markets. Without sufficient liquidity, such platforms may not be able to provide loans, which can lead to inefficiencies and limit the industry's growth. Finally, liquidity is also critical for the smooth operation of decentralized exchanges (DEXes) and automated market makers (AMMs), which rely on a constant flow of assets to maintain accurate pricing and execute trades. In all of these cases, it is essential to have not only enough liquidity but also the right kind of liquidity. That is why liquidity rebalancing is crucial in many areas of the crypto industry.

When discussing liquidity rebalancing in crypto, people mean changing the ratio of crypto assets. Such changes might be needed for several reasons. For example, traders can end up with assets they do not want to store for a long time, or a multi-chain pool of a cross-chain bridge can become unbalanced, struggling to keep up a seamless operation. In both situations, liquidity rebalancing can help to return to the proper ratio of assets and thus stabilize the system. Let's look at some examples more closely. 

Personal Portfolio Rebalancing

Rebalancing your personal crypto portfolio involves periodically reviewing and adjusting the allocation of your investments to keep them in line with your desired asset ratio based on your risk tolerance and investment objectives. This term is strongly linked with portfolio drift, a natural tendency for an investment portfolio to become imbalanced due to market changes. If left unattended, drifts pose significant risks to the success of your investment strategy.

For example, if you have allocated 50% of your portfolio to Ether (ETH) and its price has risen significantly, your portfolio may now be overweight in Ether. To rebalance, you would sell some of it and use the proceeds to purchase other cryptocurrencies you may have or add new ones to bring your portfolio back into balance.

Rebalancing can help minimize risk and maximize returns over the long term. It requires discipline and patience, as it may involve buying assets that have recently underperformed and selling assets that have recently outperformed, which may be difficult psychologically, especially for novice traders. However, by sticking to your investment strategy and regularly rebalancing your portfolio, you can ensure you are on track to achieve your financial goals.

Although most cryptocurrency traders use customized bots to maximize profits, crypto holders who are not as interested in trading, especially high-frequent ones, can also benefit from such bots. Since the crypto market is highly volatile, portfolio rebalancing may be required more frequently than expected, and bots can help to manage it more efficiently and quickly. Moreover, with advances in AI-related technologies, bots have the potential to become even more helpful by being able to analyze situations and make predictions of possible price changes, enabling traders to plan their investments more carefully. 

Popular Rebalancing Strategies

There are various strategies for portfolio rebalancing, each with its own merits and drawbacks. One of the most commonly used strategies is the Threshold Portfolio Rebalancing. 

Threshold Portfolio Rebalancing

This investment strategy puts stringent tolerance bands on each asset, limiting their movements. For instance, a cap of 10% can be set on all rises and falls. If an asset's movement breaches this threshold, it is sold or bought, depending on the situation. For example, suppose you have Ether (ETH) and Solana (SOL) in your portfolio and want an equal proportion. If you allow for a 10% deviation, the maximum permitted split will be 60/40 or 40/60. When the price of ETH rises, you sell it to purchase SOL, and vice versa. 

The effectiveness of the threshold rebalancing strategy depends on two factors - the market and the threshold width. You can set your threshold width high or low, but neither option is foolproof. For instance, a lower threshold results in less flexibility, more frequent rebalancing, and, consequently, higher transaction fees. Combined, it may lead to lower profitability. Moreover, this is unsustainable for high-volatility crypto assets, likely to breach low thresholds. 

In contrast, a high threshold ensures more flexibility, decreases the amount of times when rebalancing is needed, and lowers overall costs. 


The next popular strategy is CPPI (Constant Proportion Portfolio Insurance). Like trading in the traditional financial market, where part of investments is allocated in more conservative instruments to minimize risks, CPPI in crypto uses stablecoins. Exchanging part of the portfolio to stablecoins protects it from excessive volatility.

However, what if you solely own cryptocurrencies and the market experiences a surge? At first glance, it is an excellent opportunity to earn a substantial profit. The downside is that even a minor retracement could erase all your gains and leave you with losses.

Imagine an investor follows the 50/50 ratio, which involves holding $5,000 worth of crypto and $5,000 worth of stablecoins, and the crypto market takes a 25% hit, leading to approximately $1,250 worth of loss. If they had invested $10,000 exclusively in crypto, the losses would have been doubled. Therefore, including stablecoins shields you from significant losses and allows you to reinvest in crypto for rebalancing purposes easily.

Periodic Crypto Rebalancing

Periodic Crypto Rebalancing is a strategy that focuses on time rather than proportions or value. In this method, rebalancing of a crypto portfolio takes place at predetermined intervals such as hourly, daily, weekly, or monthly. 

Choosing a shorter rebalance period can - again - result in higher transaction costs, but it also means a lower portfolio drift. On the other hand, longer intervals mean lower adjustment costs, but the chances of portfolio drift grows. Consequently, the most suitable interval depends on how comfortable you are with taking risks and how far you can allow your portfolio to drift away from the desired balance.  

This method is one of the most straightforward portfolio management strategies because it requires little attendance, time, and calculations. All you need to do is activate the rebalancing procedure based on your schedule.

Rebalancing in Arbitrage and Market-making

While engaging in arbitrage trading, rebalancing is a crucial part of the day-to-day trading activity. Asset balance constantly changes as traders trade crypto based on their chosen arbitrage strategy. To take profits or rebalance assets across networks, traders utilize CeFi exchanges, DeFi platforms, cross-chain bridges, or even trade with someone P2P, sometimes adding a discount to speed up the process. Each way may be beneficial in a particular case, so traders have to analyze the market and find the best routes that will not consume a substantial portion of their profits. 

To automate the rebalancing process, traders frequently resort to the assistance of bots that can monitor assets and rebalance when necessary. 

The same applies to market makers that trade with users on various platforms, mainly decentralized. They find liquidity across CeFi and DeFi and sometimes use their own funds to complete orders to constantly trade with users, searching for profit opportunities they can take advantage of. As a result, they always need to rebalance their liquidity. Some makers do it manually, while others prefer to use software to speed up the process and increase their profits.

Rebalancing of Liquidity Pools

Another area where liquidity rebalancing is needed is liquidity pools, which are used by DEXes, cross-bridges, lending protocols, etc. For DEXes, this approach allows to eliminate the need for intermediaries during trades. On the other hand, it makes them rely heavily on liquidity providers to supply liquidity in pools and maintain smooth trading around the clock. Similarly, liquidity pools of bridges are also often provided by crypto holders willing to stake their tokens. 

DEXes use mathematical formulas to determine the prices of assets in liquidity pools. These formulas can differ from one exchange to another and can be adjusted to optimize the liquidity pools as needed. However, continuous trading between the pools can sometimes result in an imbalance in liquidity, especially when there is an excessive demand for a particular asset. Such an imbalance can negatively impact prices and execution times and may require rebalancing.

The same imbalance may occur on bridges, causing malfunctions and failures in severe cases. Bridges incentivize market makers to provide liquidity and rebalance it when necessary to avoid such problems.

Final Thoughts

In summary, liquidity rebalancing is essential for ensuring that markets remain efficient and effective. It helps to prevent liquidity imbalances and ensures that traders can transact without disruptions. As the world of DeFi continues to grow, liquidity rebalancing will remain an essential practice for maintaining healthy markets. When it comes to personal finance, rebalancing is as vital as it allows to ensure the sustainability and resilience of crypto portfolio and arbitrage strategies.

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