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The Impermanent Loss in DeFi

BitForex Editor
Nov 06, 2020

Liquidity pools are usually used to facilitate trading and allow Liquidity providers to make some profit, but, at times, some coins can go missing. This disappearance does not happen in a whirlwind; there is a mechanism behind it, and surely, the expected profit gets hit. The situation is referred to as Impermanent loss.

What is Impermanent Loss in DeFi?

Impermanent loss in DeFi is a temporary loss of funds that takes place when providing liquidity. It is a significant difference between holding assets and creating liquidity with them. Impermanent loss is observed in Standard Liquidity Pools(SLPs) by liquidity providers expected to provide a correct, fixed ratio of tokens where one is volatile in comparison to the other. An example is the UniSwap DAI/ETH 50/50 pool.

Let us imagine that ETH rises, the pool immediately turns to arbitrageurs to help normalize the discrepancies. Their job is to continually ensure that the pool price reflects the current world price and ensure that the tokens in the pool maintain their values. As a result, profits from token appreciation are taken away from liquidity providers. Arbitrageurs are the lucky ones here— utilizing arbitrage, of course.

Over a certain period, not too long, the pooling ratio will be reverted to its former self. However, if the LP decides to withdraw his funds while the Impermanent loss exists then the loss becomes permanent.

What Happens?

Tons of words would not do justice to the dynamics of impermanent loss; an example will give a better understanding. Below is an assumed ratio for a Uniswap ETH/DAI 50/50 pool.

This is the situation of a pooled investment by a liquidity provider. It is a smooth sail until external price differences surface. For example, on Coinbase, DAI begins to sell at $550. This is a signal for arbitrageurs to do business. They can buy DAI at cheap prices and make gains. Now, the UniSwap pool is subject to the Constant Product Market Maker. The model ensures that the more a token is bought, the higher the price becomes. So the accelerated buying of DAI on UniSwap by arbitrageurs makes the rate on the platform match the rate on Coinbase, eventually.

What Does the Arbitrageur Do?

The Constant Product Market Maker is used to maintain the correct ratio of tokens and this is when the arbitrageur comes in. The more DAI bought, the higher its price becomes. The arbitrageur will continue to buy DAI till there is no difference in the exchanges.

Plugging the values from the above table into the model, Uniswap's DAI price will hit $550 when there are 10,488.09 ETH and 19.07 DAI in the pool. Ideally, the arbitrageur buys 0.93 DAI to bring about equilibrium between the DAI prices on UniSwap and Coinbase. The amount of DAI bought costs 488.09 ETH and each DAI can go for 524.83 ETH.  The arbitrageur can gain from trade for ETH or exchange for stable coins.

The Fate Of The LP

If the LP held on to the assets,

10,000 + 20 × 550= $21,000

But due to arbitrage,

10,488.09 + 19.07 × 550 =$ 20,976.59.

The difference—impermanent loss—is $23.41. Patience on the side of the LP will see a recovery where DAI's price will return to $500. Impermanent loss becomes 0. Else, if the LP withdraw the asset immediately, the loss becomes permanent.

What Do LPs Stand To Gain From Liquidity Pools?

In the perfect world, LPs get incentives by getting a share of trading fees. The Liquidity pool distributes 0.3% of the fees gotten off each trade to the LPs. This means LPs can still make profits in the face of impermanent loss, provided that it is less than the collected fees.

Also, an additional incentive is provided through liquidity mining programs. For providing liquidity to certain pools, LPs are rewarded with extra tokens. Sometimes, the rewards are extended to the usage of a certain protocol.

The Situation With Other Popular Liquidity Pools

Curve

Another reputable liquidity pool is the one set up by Curve. The tokens paired are stable coins like USDC and DAI or coins of similar flavors like SBTC, RENBTC, and WBTC. Curve, by employing these precautions, keeps the tokens in the pool within a close range of values. Another advantage is that stable asset liquidity Pools attract more capital than non-stable asset liquidity pools. Many LPs are probably looking out for pools where they can get their absolute profits and might not have the patience for the overturn of impermanent loss. This makes Curve one of the most preferred choices. There is a minimized risk of impermanent loss since the value of one coin is slightly or not volatile to the other.

Balancer

This platform offers pools with arbitrary weights outside of the standard 50/50 model. To negate possible cases of impermanent losses, the pools can weigh one token higher than the other based on market prospects. Such weights can take the ratio of 80/20, 98/2, and so on. The impact of impermanent loss is reduced, depending on the weights of the tokens in the pool.

Bancor v2

This is the most exceptional of them all. BANCOR v2 pools adjust the weights automatically based on external prices obtained from price oracles. This automation can mitigate impermanent loss even in pools containing volatile assets.

BANCOR v2 is powered by an on-chain liquidity protocol that allows DeFi exchange on Ethereum and across other blockchains. It also prides itself as one of the first ICOs as well as one of the first liquidity pools. Bancor came in with a lot of obstacles like high gas fees, compulsory addition of BMT tokens to pools, inability to list new tokens, and impermanent losses all of which have been fixed.

To solve impermanent loss, BANCOR employs DAMM(Dynamic Automated Market Maker). The dynamic balance involves price oracles if the balance between tokens in the pool is altered. BANCOR relies on Chainlink to provide external prices for smart contracts in a simplified and decentralized manner. Its initiation ensures that the pool price and the market price are equaled without the help of arbitrageurs.

Stake Balance Vs Current Balance

 The staked balance is the amount that LPs should be allowed to withdraw, all things being equal. However, the current balance is the available funds in the pool at any given time. The current balance is also referred to as "reserve balance". Virtually all liquidity pools give incentives to market participants to bring the current balance close to the staked balance to mitigate impermanent loss.

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