Decentralized Finance (DeFi) is a nascent sector that’s nonetheless rapidly growing. If you are active in DeFi or researching yield farming or liquidity pools, you might have come across the term, “impermanent loss” and steps taken by projects to shield liquidity providers from such losses. Impermanent Loss (IL) is fundamental to the interaction for liquidity providers supplying liquidity in Automated Market Maker (AMM)-dependent protocols, including decentralized exchanges, enabling smooth token swapping.
Therefore, as we explore the subject, we must only ask ourselves what is impermanent loss and what measures AMM projects and non-AMM protocols like Genius Yield have taken to reduce or completely eliminate it.
In AMM-dependent DeFi protocols using constant product market maker formulas to maintain a 1:1 liquidity ratio, an impermanent loss is the opportunity cost or a temporary loss in funds for liquidity providers. Impermanent loss can also be used to illustrate how much profit a user would have made if they had chosen to hold onto their assets instead of supplying assets in an AMM liquidity pool.
When the price of a token making up a pair changes, arbitrageurs — mostly fine-tuned bots set to exploit market inefficiencies of any kind — step in, purchasing the price of the better-performing token in the pool, realizing a profit. Arbitrageurs will continue buying the token until there is equilibrium with external market rates.
Although the liquidity provider, who supplied both assets of the pair in the pool, earns a fee for every swap, they, on paper, take a loss due to this token appreciation. This loss is “impermanent” until the liquidity provider redeems their token, turning it permanent.
Let’s use an example to illustrate;
In, say, an LINK/USDC pool, a liquidity provider must provide both assets at a 1:1 ratio. On the other hand, traders who want to swap USDC for LINK will transact and be charged a transaction fee of 0.30% that’s then distributed to liquidity providers in the pool.
A liquidity pool must always maintain the 1:1 ratio per the constant product market maker formula. Therefore, if there is $100 of LINK, there should be an equal amount in USDC in the pool. The performance of these tokens is independent of how each performs in the external market like Coinbase or Binance. Instead, its value is determined by the liquidity pool ratio.
Let’s assume, in the LINK/USDC pool, there are 100 LINK for a total of $10k with each token trading at $10, there must be an equivalent value of 10k USDC with each USDC pegged at $1.
The total value of the pool before arbitrage is:
10,000 USDC +10*1000 LINK==20,000
If the price of LINK increases to 15 USDC in an external exchange, for example, Binance, arbitrageurs will step in and take advantage of the arbitrage opportunity to realize the profit until there is equilibrium. As more LINK is purchased in the pool, the more valuable it becomes.
Using the constant product market maker formula, the price of LINK in the pool will rise to $15 when there are 12,247.45 USDC and 816.50 LINK in the LINK/USDC pool.
As a result, arbitrageurs have to buy 183.50 LINK worth for 2,247.45 USDC and achieve equilibrium with Binance’s LINK rates at 12.25 USDC in the pool. The acquired LINK can be immediately liquidated for 15 USDC on Binance, realizing a profit of $15-$12.25==2.75 USDC exclusive of gas fees.
The total value of the pool after arbitrage is:
12,247.45 USDC +816.50 *15 LINK==24,494.90
Meanwhile,
The value of holding is: 10,000 USDC +15*1,000==25,000
The intervention of arbitrageurs means the liquidity maker receives 23.41 USDC less than they would if they had held in their wallets.
That is:
25,000–24,494.90==505.1 USDC
The 505.1 USDC is the impermanent loss.
If the price of LINK on external exchanges changes from 15 USDC to 10 USDC, the paper loss would be reversed.
Impermanent loss, as mentioned earlier, is temporary until the liquidity provider decides to withdraw their assets from the pool, turning it permanent.
DeFi protocols offer liquidity mining programs and issue additional tokens — apart from revenue accrued from swapping — to encourage liquidity provision. Sometimes, the value of these extra tokens completely covers against impermanent loss risks, making liquidity provision attractive.
Genius Yield platform doesn’t use AMM designs, and therefore, there is no impermanent loss for liquidity providers. By launching on Cardano, which uses the EUTxO model, each liquidity position supplied at a given trade range is a unique UTXO, minted as liquidity NFTs. Because the price range (price tick) a liquidity provider opts to provide liquidity doesn’t change, there is zero impermanent loss.
However, the elimination of impermanent loss in the Genius Yield platform doesn’t necessarily mean liquidity provision is risk-free. In essence, since liquidity providers have to concentrate liquidity at a specific trade range (price tick) — opening as many positions as they want, they can only earn trading fees when swapping happens within the chosen trade range. However, they lose out when the trading price shifts out of the LP’s selected trade range, which is a type of loss. For this reason, the liquidity provider must play an active role in keeping track of the trading price and manually rebalancing their liquidity provider trade range to maximize rewards.
For this exact reason, Genius Yield is building the Smart Liquidity Vault. It is a yield optimizer built above the DEX for autonomously managing liquidity positions using Artificial Intelligence and Machine Algorithms developed by the Genius Yiel team. It will execute various trading strategies based on the user’s predefined risk tolerance, expected returns, and time frame.
Watch our video on Impermanent loss: https://youtu.be/_RBYnSCQKGE
Download a full E-book on Impermanent loss here: https://t.co/CWfAS3nf1g