31 Dec 2022
Most fundamental analyses in this article were extracted from our M3TA Showcase.
Pay a visit to our M3TA 101: Episode 2 & Episode 3, both of which were published in 2022 to grasp these crypto-distinctive terms in case you find yourself not yet familiar with them:
◉ Episode 2: Automated Market Maker (AMM), Liquidity Pool (LP), Liquidity Provider
◉ Episode 3: Decentralized Exchange (DEX), Trading Pair
Otherwise, enjoy your read!
‘Impermanent Loss’ is a term in DeFi trading that refers to a looming risk incurred when liquidity providers add liquidity to an AMM protocol's liquidity pool and the moment the exchange price of either or both the assets in the pool changes, compared to the exchange price of either or both the assets at the moment the investors first add liquidity to the pool.
As AMM-based pools sustain themselves on the ratio balance of the two assets segregated in the pool, this means that the larger the change in price, the higher the impermanent loss would be. Also due to this ratio dependence, it does not matter whether a token price appreciates or depreciates; impermanent loss always exists as long as a liquidity provider and his/her liquidity deposit are in play.
The impermanent loss is called ‘impermanent’ because the loss is only realized or ‘permanent’ when the liquidity provider withdraws their assets from the liquidity pool after the currency exchange has experienced volatility, which means if the token pair returns to their initial deposit value, the loss would bounce back to 0. Yet, due to the volatility-sensitive nature of cryptocurrencies, the odd for this incidence to play out is disappointingly slim.
In standard pools, such as those from Uniswap and Spiritswap, there is a common formula that investors are able to make use of. Feel free to skip ahead to Figure 4 to access this ready-to-use prescription if you are in a hurry.
In case you are not, a basic break-down of the calculation with a theoretical example demonstrated by the USDC-WFTM pool - the largest pool by TVL on Spiritswap, a widely used DEX running on the Fantom Layer-1 chain - will be presented.
Let’s say: Token A = USDC; Token B = WFTM
◉ 1 USDC = 5 WFTM; I decide to stake 10 USDC & 50 WFTM.
◉ Total balance in the USDC-WFTM pool after my stake: 100 USDC & 500 WFTM, which means that I have acquired a 10% stake.
◉ After 1 month, 1 USDC = 10 WFTM on the market.
◉ No trading fees are concerned in this example.
Put the formulae to the test, shall we?
Having understood the calculation method, why don’t we check on our stake at this point? Since USDC is pegged to US$1, the calculation would look like this:
As the WFTM depreciates, it goes without saying that investors do not make profit irregardless of whether they have decided to provide liquidity for the pool or not. However, we cannot help but notice that if they were not to stake their funds, more of the assets would be reserved in their pockets than if they did, indicated by a slight difference of $15 and $14.14 in earnings, respectively, or a loss of 5.73% in value.
This pattern works the other way round, too. As the WFTM appreciates over time, holding would render as the optimal way to attain the highest asset value rather than partaking in liquidity staking.
Given that the initial contribution was only a tiny sum, the value loss in this instance was not very significant. However, impermanent loss can result in substantial losses as your staking funds grow greater.
Just bear in mind that the further the price of one token deviates from its initial staking mark, the higher the ratio of losses accounted compared to HODLing:
◉ 1.25x price change = 0.6% loss
◉ 1.50x price change = 2.0% loss
◉ 1.75x price change = 3.8% loss
◉ 2x price change = 5.7% loss
◉ 3x price change = 13.4% loss
◉ 4x price change = 20.0% loss
◉ 5x price change = 25.5% loss
All theories aside, on-chain data narrates a different story for the USDC-WFTM pool. It seems that the pool has been boasting quite a wide range of impermanent loss since May 2022 despite its enormous trading volume on the Spiritswap exchange, once reaching up to $700M early last year 2022. This could be one of the direct consequences from the heavy rumble of the summer $LUNA calamity and the early Thanksgiving’s FTX catastrophy. The huge gap demonstrates a close correspondence of votality in the pool, mostly from the perspective of the wrapped Fantom-native token since USDC is a stablecoin.
Liquidity providers are well aware of this inevitable dilemma dubbed ‘impermanent loss’, and yet why do they persist in their line of work? The simple answers are: that is not where they earn their profit and there are ways to minimize the risk of impermanent loss.
Since AMM-based pools do not adopt the modus operandi of a centralized order book, there is no central entity to intervene on trading fees, either. That is to say, except for gas fees - which is already considerably high, the complete sum of trading fees will be delivered to liquidity providers whose staking percentage in the pool would be of concern to determine how much they are able to earn.
Action: Find pools with high trading volume such as DAI-GNS on Uniswap, and WETH - USDT on Uniswap to offset the temporary loss incurred.
Usually, investors are more likely to provide their assets to liquidity pools that have tokens move in a narrow price range so they can lower the risk of impermanent loss. Or simply steer clear of liquidity provision when volatility has been warned to be on the horizon. These pools can also assume the role as a safe hedge against a bear market condition, just like how 2022 was.
Action: Provide liquidity to trading pairs that contain stablecoins (DAI, USDT, USDC, etc.) or to different versions of wrapped coins. Some of the most popular ones are: USDC-WFTM and ETH-WFTM on Spookyswap, USDT-BUSD and USDC-BUSD on Pancakeswap, etc. In addition, if one of the assets in the trading pair is believed to take a bullish charge sooner than the other, do not provide liquidity to this pool.
Another way for investors to eliminate the exposure to impermanent loss is to wait for the assets' prices to go back (either up or down) to their deposit prices and then make their liquidity withdrawals. But as we have mentioned earlier, this could take a while, if any.
This one is a no brainer, especially to new investors. As you cut back on your investment, you are bestowed with an opportunity to experiment with different AMMs to see what works best for your trading routine, what works best in certain market conditions, and how to spot a faulty forked AMMs (DeFi protocols allow developers to limitlessly and permissionlessly fork their own AMMs).
Action: For each pool, divide your eggs (funds) into different baskets (liquidity pools) in small value to estimate how much profit you are likely to make and pay attention to some visible patterns before risking a more considerable sum. If you are already all-in, probably considering cutting down the liquidity in half. Of course, in all fairness, this would also mean you gain half as much of your profit.
High APY is no doubt a great plus to investors, but abnormally high APY comes raised eyebrows: what’s the catch, bruh? Just as how interest rates in banks work, higher APY equals bigger risks and short-term sacrifices while you lock your money in one place for a long-long-long time. This can leave long-term scars on investors, especially when a rug pull makes its sudden appearance.
There are some exchanges that allow risk-averse investors to provide liquidity for one asset in the liquidity pool only, which eventually nips impermanent loss in the bud. With decentralized oracles serving as the price feed for decentralized exchanges, liquidity pools can automatically adapt whenever there is a major change in pricing without having to comply with the traditional trading pair ratio, hence no impermanent loss.
To revoke the far-reaching impact of impermanent loss on those conventional AMM-operated pools that usually split the assets’ quantity right down in the middle at 50/50, some services such as Balancer offer multiple liquidated pool ratios - which are available to pools that:
EITHER comprise more than 2 assets and inherently involve more than 1 ratio in calculation
OR set up an uneven ratio between 2 assets
Investors are said to be exposed to more manageable risk if the volatile contribution between the two assets only takes up as little as 20% in an 80/20 pool, instead of 50%.
◉ No. Actually it's more beneficial for spot traders, holders and long-positioned traders. Liquidity providers only experience loss from a change in price, for better or for worse.
◉ (1) If trading volume starts experiencing big dips, this could consequently take its toll on the central reward of liquidity providers, which is transaction fees.
◉ (2) Your own liquidity funding amount. If you are not willing to accept the fact that your risk might at once exceeds your return, you should consider cutting down on your liquidity funding since that scenario could become a common scene for liquidity providers in light of impermanent loss, according to a group research conducted in 2021 posted by Stefan Loesch - Managing Partner at LexByte.