The Risks of Impermanent Loss in Liquidity Pools

The Risks of Impermanent Loss in Liquidity Pools


Have you ever provided liquidity in a pool to realize that some of your coins have disappeared?
In times of high market volatility, the supply of tokens in a liquidity pool can lead to losses (compared to a buy & hold strategy; all this thanks to slippage).
With Uniswap (Bancor, Yearn Finance, Curve, Cream, Pancake etc) anyone can provide liquidity and earn a return (harvest farming and / or fees paid by users who take advantage of the liquidity of the protocol). Liquidity in finance is everything. Without liquidity, decentralized finance (DEFI) cannot work either. For example, Uniswap operates through liquidity reserves that allow the protocol to act as an Automated Market Maker (AMM), without the need for an order book.
However, by providing pairs of tokens, there is the phenomenon of "Impermanent Loss" which is a major disincentive for those who would like to provide liquidity in the various pools.
These pools try to minimize token price divergences by reducing the risk of impermanent loss.
Essentially, these are temporary token losses that occur when providing liquidity. Impermanent loss is usually observed in standard liquidity pools where the liquidity provider (LP) must provide both tokens in a certain ratio (e.g. 10 Cake and 0.25 BNB) and one of the two tokens is volatile relative to the other. Indeed, it could happen that the value expressed in terms of fiat currency increases, but to a lesser extent than a buy and hold strategy.
The impermanent loss is the difference between keeping the tokens in an automated market maker and keeping them in your wallet.
Occurs when the price of tokens within an automated market maker diverges in any direction. The greater the divergence, the greater the impermanent loss.
When the relative prices of the tokens in the pool return to the state they were in when you entered the AMM, the loss disappears and you earn 100% of the trading fees.

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Or let's consider DAI / ETH on Uniswap.
If the ETH increases in value, the pool has to rely on arbitrage systems that continuously ensure that the pool reflects the real world price (keeping the same value of both tokens in the pool). This basically leads to a situation where the profit from the appreciated token is taken away from the liquidity provider. At this point, if the LP decides to withdraw its cash, the temporary loss becomes permanent.
If, on the other hand, the exchange ratio between two tokens of a liquidity pool tends to remain constant, liquidity providers run less risk and can rely more on the possibility that trading fees will guarantee them a profit.
In other words, the most intuitive way to eliminate the risk of impermanent loss is to use liquidity pools consisting of an exchange pair in which the price of one token does not appreciate or decrease compared to the other.
Also called "mirror assets", they allow liquidity providers to earn from fees knowing that the ratio between the tokens will remain more or less stable.

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The sETH / ETH pool represents the prototype:

sETH is the Ether version of the Synthetix protocol and stands in a 1: 1 ratio to ETH. In general, a part of the SNX added to the total supply through the inflationary monetary policy is distributed as a reward to users who provide liquidity in the pair sETH / ETH on Uniswap.
Through this incentive mechanism, one of the largest liquidity pools on Uniswap has been created, which allows traders to buy SNXs to start trading or sell them to take profits.

Whether the price of ether increases or decreases, liquidity providers need not fear that one of the tokens will appreciate drastically over the other, and that their gain may be affected by the impermanent loss.
Another similar example is given by pools made up of a cryptocurrency and its wrapped form.
The typical example is the wETH / ETH exchange pair.
WETH, or Wrapped Ether, is the tokenized version of Ether. It is an ERC20 token generated as a result of Ether being placed in a special contract (Wrapped Bitcoin also exists!). It is used to use Ether in smart contracts, exploiting the functionality of the ERC20 tokens.
Regarding solutions that exploit liquidity pools with constant exchange ratio, Curve should be mentioned.

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Curve is a decentralized exchange like Uniswap, but designed for the exchange of stablecoins (DAI and USDC). This tool allows users and smart contracts to trade between stablecoins and earn commission from liquidity providers. This liquidity pool is also used in the Compound protocol (or on Yearn.finance), where it generates even more return for liquidity providers.
Since the liquidity pools on Curve are made up of stablecoins, you can know in advance that the exchange ratio will always be 1: 1.
In general, Curve is able to offer some of the highest lending rates on the market, in particular by aggregating returns across the lending ecosystem to find the most profitable rates.


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