Welcome back. Previously, we took a deep dive into the math of automated market making, liquidity pools, and how to think about divergence loss (DL) or as it is more commonly known (and poorly named), impermanent loss. (Part 1 here, Part 2 here)
Today, I’ll share a few more concepts commonly asked about participating in the Sushi Liquidity Pool (SLP) staking and examples assessing the impact of DL compared to projected staking rewards.
What is the SLP token, and do I determine its value?
Back in part 1, we learned that when you participate in liquidity pools, you basically hand over your tokens (50% value ETH and ILV) to the automated market. You essentially sold your tokens in exchange for a Sushi Liquidity Pool (SLP) token, representing a part ownership in the pool. You are able to sell this SLP, and remove liquidity equal to your percentage share from the pool, receiving an appropriate amount of ILV and ETH in the new ratio. Selling your SLP also entitles you to swap fees generated while you participated in the pool. This is automatic, as each transaction just adds 0.25% value to the pool, so there’s nothing separate to do or claim. But how many ILV and ETH do you get back?
Divergence loss teaches us that we will get fewer of the token that increased in value more relative to what you put in. Before you calculate the number of units you receive, it's important to know the value of the SLP token itself. Just like any other crypto token, there is a value associated with the ILV/ETH SLP pair token. It’s relatively arbitrary from an absolute dollar value, and just accommodates the addition or removal of liquidity, the addition of fees, and the changing price of the two pooled assets. For ILV/ETH, you can see the price here, or look up the contract on Etherscan to see the current price. From this price, you can calculate how many ILV and ETH you would receive by selling your SLP.
Today (8/29/2021), the ILV/ETH pair is valued at about $2650. Knowing each SLP is half ETH and half ILV, that means each SLP is currently worth $1325 in ETH, and $1325 in ILV. At today’s prices (ETH $3236, ILV $511), you would receive 0.41 ETH and 2.59 ILV for each sold SLP. How this compares to what you originally added to the pool depends on the price ratio on the day you entered the pool, as well as fees added during your time in the pool.
Beyond just knowing how many ETH and ILV you have today, you're likely to wonder how many you'll have at your future price predictions. We’ll do a new example to see how this works for a future value of ETH and ILV. Imagine you initially added liquidity when prices were $3250 for ETH and $520 for ILV, and you bought 1 SLP. This required you to pool 0.415 ETH and 2.596 ILV, and SLP was initially valued at $2700 each. A year later, the price of ETH is now $4300 and ILV is at $875. In this case, you would receive 0.477 ETH and 2.346 ILV. We’ll get into the math more shortly, but the key aspect is that the price of ILV increased slightly more than ETH, so you received a bit less ILV and a bit more ETH than when you first started. You can calculate this for yourself using the Imperm Loss tab on my calculator here.
Example 1: Minor Ratio Changes
Continuing this example, to understand our value exiting the pool, we need to consider a number of other factors, specifically divergence loss and the pool usage over time. We’ll take divergence loss first. Our initial price ratio was $3250/$520 = 6.25 and our final ratio was $4300/$875 = 4.91. As the ratio is smaller at the end, we know ILV appreciated more in price than ETH. Plugging this into the divergence loss equation, we can see that our loss versus HODLing our tokens is 0.72%.
HODLing would have given us a new value of $4057, so with Divergence loss, we actually receive $4028 before fees. Half of this is ETH and half is ILV, so you can just take $4028 divided by two, and then divide by the current price of ETH or ILV to determine how many tokens you receive.
That ignores Sushi swap fees though. In my calculator, in cell B4, you can add an estimated average pool usage to calculate how much you would have earned in fees during your time pooling. At 2.5% average pool usage, I estimate that you would earn $76 fees across the year, which more than makes up for the -$29 you lost due to divergence loss. This is even before your Illuvium staking rewards, so in this situation and relative token price change, the SLP was definitely a good idea.
How does rev dis consider staked SLP?
We’ll take an intermission in examples to answer another question - how does Illuvium revenue distribution consider SLP staking? First of all, those staking SLP are rev dis eligible, and your pool weighting does carry over to revenue distribution. (See my staking posts for more details) But how much rev dis do you earn? I don’t have an official answer from the team, but my projection is that rev dis will take a snapshot of all staking token holders at the time of distribution and issue the corresponding ILV. For the SLP tokens, at any moment in time, there is a corresponding number of ETH and ILV that these tokens are worth. We just looked at an example, and in this case, the 1 SLP staker would actually be holding an equivalent of 2.346 ILV at the prices. I estimate it is this number that determines your rev dis, applying your staking weight, so if you were locked for 52 weeks, you would earn rev dis on 4.692 ILV. If the rev dis were $10 per ILV, you would get $46.92, plus $10 multiplied by all of your claimed ILV rewards, which also earn at the 2x weight. If you don’t want to do math, you can also go to zapper.fi, and click on Staking, which will show you the current value of your SLP, along with the number of ILV and ETH tied to your stake.
What about Staking Rewards?
Continuing this example, we need to consider the value of staking rewards as well. By my current estimates (as of 8/29/2021), I project that staking 1 SLP would yield 5.192 ILV in SLP rewards over the full period of yield farming (See my other posts on staking for more details). Assigning a value to this, my calculator uses the price in cell C10 for the value of ILV earned. This means that relative to HODLing ILV and ETH, which would have been worth $4057, your value for staking in the SLP would be $8951, an increase of 120% in rewards due to staking and pooling. To launch the current calculator version (1.22), this does not include any compounding due to claiming rewards throughout the staking period. Use the SLP tab if you’d like more information on potential compounding of ILV rewards.
Entering the identical $2700 investment in the ILV tab, I project you would earn 1.348 ILV in staking rewards over the same time period, meaning the value of staking in the SLP earned you 3.844 additional ILV compared to the ILV pool.
Remember there are a lot of assumptions in these projections, so please review my other posts for more details and to fully understand how staking rewards work.
The other big risk
In addition, the other major risk not yet discussed is the smart contract risk of liquidity pooling. By entering the liquidity pool, you are giving up your ILV and ETH in exchange for an SLP token. Should that contract be hacked and drained of funds, you would be left holding a token now tied to a lower volume or empty pool, with no way to recover your original tokens or investment. While I trust Sushi and the Illuvium developers, there is certainly a target on liquidity pools and staking protocols to hack them and remove funds. This is an added risk of pooling over just HODLing tokens in a hardware wallet.
Example 2: The ILV Bullish Divergence Scenario
We’ll do two more examples. I’ll call the first one the bullish divergence scenario, where ILV moons relative to ETH. In the case of only staking ILV, you would be sitting pretty, as all your original holding plus rewards are in the currency that had the huge gain. Because of divergence loss, someone in the liquidity pool may not be as happy.
We’ll leave everything else the same for simplicity sake, and just assume that ETH goes down slightly to $2500 from $3250, and that ILV goes crazy, jumping from $500 to $4500 per token. In this case, our divergence loss would jump to 46.13%. This means our HODL value would have been $13,188, while our cashed-in SLP token will only net us $7,104. Fees help recoup a little of this, bringing us back to $7,216, but in this scenario, we actually lost nearly $6,000 in value. Before staking rewards, that is.
The huge benefit of staking with Illuvium when the ILV price appreciates is that our rewards are paid in ILV, not dollars. That is why when ILV price goes up, the APY goes up, as the rewards we earn are worth more. The number of staking rewards received are identical to the example before, but now, instead of the ILV being worth $850, each token is worth $4500. This means we have 5.362 ILV at the end of staking, worth over $24,000. This greatly exceeds our loss from divergence, meaning we are actually up over 130% compared to just HODLing the tokens.
Example 3: The ILV Bearish Divergence Scenario
Obviously, the worst thing that could happen to investors in ILV would be for the project to fail and go to zero. In that case, we’re all screwed, as both our rewards and original stake is zero. The downside for those in the SLP pool is greater, as we needed to add both ETH and ILV, and the crash of ILV will render the SLP token worthless. Also, the SLP generally attracts larger investments, in part because of higher gas fees to both stake and claim rewards in the SLP.
But what if Illuvium just does okay, but ETH takes off? This is the next worst case scenario for the SLP investor. Let’s say due to ILV dilution and the game not attracting as many players or a bear market for NFTs, the token price actually decreases from $500 to $250, while ETH does incredibly well, hitting $15,000. What would this mean for our investment?
At this ratio, we have huge price divergence again, but now with ETH increasing relative to ILV. Divergence loss means we would lose 40.61% compared to just HODLing ETH and ILV. If we didn’t pool our $2700 in ETH and ILV, we would have taken advantage of the huge gain in ETH to compensate for our loss in ILV, and our investment would be worth $6905. Instead, we pooled and staked our SLP, and ended up with $4101, a loss of $2804. We still made money compared to our initial investment, but just not as much as we could have if we just held onto ETH.
Unfortunately here, our ILV rewards are also worth less than we had hoped, and the same 5.362 ILV we earned are now only worth $1340, meaning even after rewards, we are still -17% compared to just holding ETH, not to mention the value of the ETH that we swapped for ILV in the first place.
I hope looking at these scenarios helps you better understand what Impermanent Loss (DIVERGENCE LOSS!) is, and you can make a better informed decision as you consider participating in liquidity pools and staking protocols. Currently, the rewards offered by Illuvium for the liquidity pool remain quite generous, and if you are bullish on the project, often they will offset potential impact from price divergence. I do expect rewards to decrease over time as rewards decay by 3% every two weeks, and are also decreased as more people join the staking pools. That said, if you’re reading this near the time of publication and are able to stake enough to offset higher gas fees, the SLP remains quite attractive. I share this to help you, though honestly, I am a participant in the SLP, so the more people that join, the lower my rewards. Feel free to like post this and my other articles so I can make a couple bucks to offset my “losses” from sharing this project and helping to teach others how DeFi works. Please consider joining my Patreon for my newsletter, updates to models, and my latest thoughts between articles.
I hope you enjoyed this series, and please share any feedback below, or send me a note on the Illuvium Discord @Deraji#0798. Best of luck on your investing!