Foreword: The decentralized market maker model is very popular, and the liquidity provider that provides liquidity for decentralized transactions is the key role. Providing liquidity can earn fee income or tokens, but the current design does not guarantee certain income. If the price deviation is large, providing liquidity may also cause losses relative to holding assets. If the value of held assets rises faster, the combined assets in the liquidity pool may be less than the value of the combined assets held. Of course, some people think that it cannot be regarded as a loss, it is essentially a matter of asset portfolio rebalancing. In any case, as a liquidity provider, when providing liquidity to liquidity pools such as Uniswap and Balancer, attention needs to be paid to the issue of relative income. In order to solve this problem, Bancor proposed to use oracles to minimize price deviations and other measures. The writer is Nate Hindman, translated by “JT” from the “Blue Fox Notes” community.
DeFi has a bad secret: users who provide liquidity to an automated market maker (AMM) may see their pledged tokens lose value compared to simply holding their tokens. Nevertheless, AMM technology has made great strides.
This risk is called “impermanent loss” (Blue Fox notes: impermanent loss here means temporary loss, but this expression is not precise enough, more like “value impairment”), it hinders many mainstream And institutional users to provide liquidity. Because unlike most equity pledged products, AMM faces the following risks: its return performance may be inferior to basic buying and holding strategies. (Blue Fox Notes: In the staking economy, one is to have the exposure of the token, and the other is to be able to harvest more tokens)
Some users are completely unaware of this risk, while others have a vague understanding of this concept. However, most people do not really understand how and why “impermanent losses” occur.
This article attempts to explain “impermanent loss” in simple terms (Blue Fox notes: if it is more difficult to understand, you can directly replace it with “value impairment”), and explore potential methods to mitigate this loss through the design of AMM. This solution Compared with arbitrageurs, it is more beneficial to liquidity providers.
What is “impermanent loss”?
In simple terms, impermanent losses refer to the difference in value between holding tokens in AMM and holding tokens in your own wallet.
This happens when the token price in AMM deviates in any direction. The greater the deviation, the greater the impermanent loss.
Why is there an “impermanent loss”?
Because as long as the relative price of the tokens in the AMM returns to its original state, then the loss disappears and you can get 100% of the transaction fee. However, this situation rarely occurs. Usually, impermanent losses will become permanent losses, swallowing your transaction fee income or causing negative returns to users.
Although LINK rose 700% last year (denominated in USD), the return on providing liquidity for LINK / ETH on Uniswap fell by -56.67%.
Why does this happen?
In order to understand how impermanent losses occur, we first need to understand the operating model of AMM pricing and the role played by arbitrageurs. In its original form, AMM is disconnected from the external market. If the price of tokens in the external market changes, AMM will not automatically adjust its price. It requires arbitrageurs to come in to buy undervalued assets or sell overvalued assets until the price offered by AMM matches the external market.
In this process, the profits drawn by arbitrageurs come from the pockets of liquidity providers, which can lead to impermanent losses.
For example, consider that there are two AMM pools with ETH / DAI assets, each accounting for 50%. As shown below: Changes in Ethereum prices provide arbitrageurs with the opportunity to sacrifice liquidity providers.
If you look at different price changes, you will find that even small changes in the price of ETH can cause liquidity providers to suffer impermanent losses:
Obviously, if AMM wants to be widely adopted by ordinary users and organizations, this problem needs to be solved.
If users expect to continue to monitor changes in AMM and take action accordingly, the liquidity reserve will become a game only for advanced traders.
Rather than designing a second layer tool for monitoring and managing AMM risks, it is better to mitigate impermanent losses at the protocol layer.
How to mitigate impermanent losses?
Fortunately, the crypto industry is fighting against impermanent losses and making progress. This progress started when people realized that if we can minimize the price deviation of tokens in AMM, we can reduce the risk of impermanent losses. If the relative prices between the tokens in AMM remain the same (assuming that none of them have failed), then the liquidity provider takes less risk and is confident of winning profits through transaction fees.
Therefore, it turns out that AMMs (or tokens that maintain a constant price ratio) with “mirror assets” are particularly resistant to impermanent losses, and attract a lot of liquidity due to their profit-optimized structure. These include the AMM on Uniswap (such as sETH / ETH pool), and the stablecoin AMM on Curve (such as DAI / USDC / USDT / sUSD).
Since the price deviation between sETH and ETH is small, the impermanent loss of sETH / ETH AMM is almost negligible.
However, AMM with mirrored assets is essentially limited to stablecoins or packaging and synthetic tokens. In addition, when providing liquidity, users cannot maintain their long positions, but must hold additional “reserve” assets. Bancor V2 will be launched in June 2020, and its purpose is to extend the concept of mirrored asset AMM to volatile tokens to solve the above problems.
By integrating with Chainlink’s price oracle, Bancor V2 supports the creation of AMM with anchored liquidity reserve assets, which keeps the relative value of tokens in AMM unchanged. This new type of AMM effectively relies on oracles to balance prices, rather than relying solely on arbitrageurs. In this way, they can eliminate the risk of impermanent losses of stable and volatile tokens.
Importantly, this design also allows users to provide liquidity, while at the same time, no need to hold additional packaging assets or synthetic assets. Instead, you can provide liquidity while still having 100% exposure to a single token in AMM.
Bancor V2 supports the creation of AMM with anchored liquidity reserves. This type of AMM maintains the relative value of its reserve assets unchanged, thereby eliminating its risk of impermanent losses.
Impermanent losses are not conducive to AMM’s commitment as a civilian liquidity reserve mechanism, which supports the passive market making of any user with potential capital.
Minimizing the risk of liquidity reserves and the benefits of having a single token exposure make AMM a more powerful and effective solution to drive decentralized liquidity.