What the #$*&! Is Impermanent Loss, and Why Do I Care? Illuvium Edition - Part 2: Why Would Anyone Ever Pool?

What the #$*&! Is Impermanent Loss, and Why Do I Care? Illuvium Edition - Part 2: Why Would Anyone Ever Pool?

By Deraji | ILVFi | 30 Aug 2021


Welcome back!  In part 1, we discussed the idea of DeFi exchanges and Automated market making (AMM) compared to centralized exchanges, and introduced the big, scary, confusing risk known as impermanent loss.  I shared why it’s a stupid name, and why I’ll call it divergent loss going forward.  Today, we’ll look at the types of reward for adding liquidity to the pool, and start to answer why the DAO is incentivizing liquidity pooling.

Why would anyone pool then?

You might be asking yourself, “why would I endure the risk of divergence loss?” First, thank you for calling it divergence loss.  Presumably if you’re still reading and found my blog in the first place, you’re interested in Illuvium.  There are two aspects that incentivize someone to participate in AMM liquidity pools.  The first benefit is transaction fees.  On Sushi, every swap transaction incurs a 0.3% swap fee, with 0.05% going to staking Sushi token holders, and the remaining 0.25% added back to the pool.  This is done automatically, and there is nothing to claim to receive this reward.  Remember, you just bought a percentage of the pool above.  Any time someone swaps, 0.25% of that transaction is just added back to the pool.

To determine how much you can expect to gain from transaction fees, you can look at the analytics of the pool here.  There’s a lot of interesting information on this page, at least to me, because I’m a nerd as I’m sure you’ve realized by now. 

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If you only care about your fees earned, the only numbers you need are the pool utilization (lower right), and the dollar value of your SLP pooled.  Sticking with the example above, we’ll say you have $6,500 pooled, and the utilization on this day was 1.70%.  Take your value multiplied by the utilization, multiplied by 0.25%, giving you $0.27. 

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You made $0.27 thanks to transaction fees today.  Annually, this would be $100.76 if utilization stayed at this level.  The day I took the screenshot was definitely a low volume day, at least for the recent ILV/ETH Sushi pool utilization.

Mmm...Land sale revenue

Aside from normal swapping of ILV and ETH, the big upcoming land sale and revenue distribution is likely to be a boon for SLP poolers.  Early estimates have speculated $100 million in revenue from the sale.  The DAO distributes 100% of this revenue back to staking ILV token holders.  This distribution is done in ILV, which is purchased from the Sushi liquidity pool!  Not only will you receive ILV based on your current staked ownership, but you will also receive the pool fees.  That $100 million would be about a 50% utilization of the pool, which means your share would be $6500 x 50% x 0.25% or $8.13.  It’s not much, but I’m not turning it down!

The real current pooling value - Staking Rewards

Currently, the much larger incentive to add liquidity to the Sushi ILV/ETH pair are the staking rewards from Illuvium.  As of today, these rewards remain above 600% APY, meaning at current prices (ILV at $520), your $6500 would earn about 0.2055 ILV per day.  Remember, APY is dynamic, and decreases every two weeks by 3% and decreases as more people stake in the pool.

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It is this reward that actually makes the SLP currently worth it, but the long term value and impact of divergence loss are determined by your eventual selling price.  We'll get into more examples and impact of staking rewards in Part 3.

Why pair with ETH?

Something you may have asked yourself is why is ILV paired with ETH, perhaps rather than a stable coin?  There are two big reasons in my opinion.  First, the game will definitely be international, so tying to a stable coin, most of which are US Dollar based, would require a swap by international investors into stable coin.  Not really a big deal, but it's something. 

The bigger reason is that ETH is also a dynamic price, and if you’re an ILV bull, you’re also likely a believer in the blockchain network where it's located.  If that’s the case, you likely also believe the price of ETH will increase over time.  This improves our situation for divergence loss, as the price ratio will likely stay closer together than if ILV was paired with a stable coin.  

Imagine a situation where ILV goes from $520 to $2500 over a period of time, and the value of ETH changes from $3250 to $6000.  In this case our initial ratio is 6.25 and our final ratio is 2.4.  Using the formula from part 1 for divergence loss, we would incur a loss of 10.45%.  But what if our Sushi pair was ILV/USDC?  In that case, our initial ratio would be 520 ($520/$1), and our final ratio would be 2500 ($2500/$1).  Our divergence loss in this scenario jumps to 24.49%, meaning pooling would cause us a greater loss.  Being dynamic, pairing with ETH and both projects being successful also helps to limit divergence loss.  

There is a dark side to this.  In a situation where ILV succeeds, but ETH fails (or vice versa), our divergence loss increases.  Let’s say ILV goes from $520 to $2500, but ETH falls from $3250 to $1500.  In this situation, divergence loss would be 43.46%.  That is what I meant by situation 3 previously where the two projects actually diverge MORE.  By pooling, you now don’t just care about the price of ILV, but also the performance of ETH, and most specifically, you care about the ratio of the two.

Why Incentivize the SLP?

From the Illuvium tokenomics, you know that rewards are divided with 80% of staking rewards going to the liquidity pool stakers, while 20% goes to those directly staking ILV.  You may have asked why wouldn’t the DAO want more people to stake the token directly?  The answer to that is that staking the token is a dead end for trading, and hinders the revenue distribution model.  Buying and staking ILV locks that token away from trading for up to a year, and potentially longer.  With only 630,000 ILV currently in circulation, that means there’s a finite limit to the number of stakers, and if all tokens are to be locked up, the DAO would be unable to buy ILV to distribute as revenue.  The price of ILV would jump, but there would be no trading because there would be no shares left.  When tokens unlock, there would be a rush to equilibrium in price as early vesting ILV would cash in, and there would be huge volatility in the short term before stabilizing.  

By incentivizing the liquidity pool, they ensure sustainability of the revenue distribution system and lower price volatility.  They also need to insure sufficient liquidity in the pool to accommodate major transactions, such as revenue distribution following the land sale.  Imagine if there was only $50 million in liquidity, and the DAO needed to purchase $100 million of ILV.  Even at the current liquidity levels, the DAO needs to be careful to space out their Vault purchases to avoid major price action and conduct their transactions randomly to avoid the ability of traders to take advantage of short term price swings.  By increasing the liquidity in the pool, this enables such transactions to be accommodated with greater ease and less opportunity for price manipulation.  

Since everyone staking in the liquidity pool is taking on the risk of divergence loss, the rewards must significantly outpace risk for those bullish on the project.  That is the reason the rewards are stacked significantly in favor of the SLP.

Tomorrow, we’ll look at different examples to compare the impact of divergence loss compared to projected rewards for staking.

 

Thanks as always for reading, and please share your comments and feedback below!

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Deraji
Deraji

Crypto curious thinker, amateur economist, geriatric millennial gamer passionate about Illuvium. Happy to share my economic and financial assessment of this unique blockchain NFT Play-to-Earn project. patreon.com/ilvfi


ILVFi
ILVFi

ILVFI focuses on the upcoming P2E game, Illuvium, the first proposed AAA-quality video game based on blockchain technology and NFT ownership. We'll focus on both the game play, as well as the in-game and ILV governance token economics.

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