Hedged Market Making
Hedged Market Making extends Internal Market Making by offloading residual interest rate risk to external markets while continuing to earn LP fees and spreads inside XCCY.
Core Idea
Instead of keeping DV01 fully neutral within XCCY only, the strategy allows:
LP positions to run with controlled DV01
external hedges to absorb rate movements
tighter quoting and higher capital utilization
This is especially useful during:
strong directional rate regimes
structural demand imbalance
periods of rising or falling base yields
Internal Leg (XCCY)
Inside XCCY, the market maker:
provides liquidity across selected tenors
skews quotes based on internal DV01
prioritizes pools with the highest fee density
allows some DV01 drift to improve fill rates
This increases fee capture but introduces exposure.
External Hedge Leg
Residual DV01 is hedged externally using floating-rate instruments.
Common hedge venues include:
Lending Markets (Aave, Compound, Morpho)
Supply or borrow the underlying asset
Use floating APY exposure to offset fixed-rate risk
Example:
Long fixed DV01 in XCCY
Borrow USDC or ETH in Aave to gain floating exposure
Staking & LSD Yields
ETH-based strategies can hedge via:
staking ETH
holding LSDs (stETH, rETH, etc.)
These naturally track ETH floating yield regimes.
Perpetual Funding Rates (Selective)
In some cases:
funding rates on perp markets correlate with short-term yields
funding exposure can partially hedge rate risk
This is opportunistic and requires careful monitoring.
DV01 Matching Across Systems
The key requirement is rate sensitivity alignment:
Estimate DV01 per pool and tenor in XCCY
Estimate DV01 of external positions
Hedge to a tolerance band rather than exact zero
Perfect neutrality is not required. Stability is.
Capital Efficiency Benefits
Hedged MM allows:
tighter quotes
deeper liquidity
higher LP fee capture
reduced need for internal rebalancing
Portfolio margin and X-Mode further improve efficiency.
Operational Flow
Deploy LP liquidity in XCCY
Monitor net DV01 continuously
Hedge excess DV01 externally
Adjust hedge size as liquidity is consumed
Periodically rebalance across tenors
Automation is strongly recommended.
Risks & Considerations
Hedge basis risk (rates don’t move perfectly together)
External protocol risks (liquidation, oracle issues)
Correlation breaks during stress events
The strategy is defensive, not risk-free.
When This Strategy Fits
professional market makers
funds running multi-venue books
DAO treasuries seeking stable fee income
Less suitable for passive LPs.
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