While investors are sometimes attracted to DeFi by the four-digit APYs on offer, temporary loss frequently erodes any potential earnings investors may have accrued.
Impermanent loss is one of the most well-known hazards that investors face while providing liquidity to a decentralized finance (DeFi) automated market maker (AMM). Although it is not a direct loss experienced by the liquidity provider’s (LP) position, but rather an opportunity cost associated with just buying and holding the same assets, the prospect of receiving less value after withdrawal is enough to deter many investors from DeFi.
Impermanent loss is determined by the volatility of the two assets in the equal-ratio pool – the more one item swings up or down in relation to the other, the greater the impermanent loss. Providing liquidity to stablecoins or avoiding volatile asset combinations is a simple method to mitigate temporary loss. However, the returns on these tactics may be less appealing.
Thus, the question is: Are there ways to engage in a high-yield LP pool while minimizing temporary loss?
Fortunately for ordinary investors, the answer is yes, as new developments continue to address current issues in the DeFi industry, allowing traders to prevent temporary loss in a variety of ways.
Uneven liquidity pools contribute to the reduction of temporary loss.
When people discuss impermanent loss, they frequently refer to the typical 50/50 equal-ratio two-asset pool – that is, investors must give liquidity to two assets of equal value. As DeFi systems evolve, irregular liquidity pools have been included to aid in the reduction of temporary loss.
As illustrated in the graph below, the magnitude of the downside from an equal-ratio pool is significantly greater than the magnitude of the downside from an uneven pool. When the relative prices of two assets remain constant — for example, when Ether (ETH) climbs or declines by 10% compared to USD Coin (USDC), the more unequal the ratio of the two assets, the less the temporary loss.
Since the beginning of 2021, DeFi technologies like as Balancer have enabled the creation of uneven liquidity pools. Investors can choose from a number of unequal pools to find the greatest fit.
Multi-asset liquidity pools are a positive development.
Apart from compensating for uneven liquidity pools, multi-asset liquidity pools can assist mitigate impermanent loss. Diversification effects are triggered by merely adding new assets to the pool. For instance, given the same price movement in Wrapped Bitcoin (WBTC), the USDC-WBTC-USDT tri-pool has a lower impermanent loss than the USDC-WBTC equal-ratio pool, as illustrated below.
As with the two-asset liquidity pool, the higher the correlation of the assets in the multi-asset pool, the greater the temporary loss, and vice versa. The three-dimensional graphs below illustrate the impermanent loss in a tri-pool at various levels of Token 1 and Token 2 price changes relative to the stablecoin, assuming the pool contains one stablecoin.
When the relative price change between Token 1 and the stablecoin (294 percent) is extremely close to the relative price change between Token 2 and the stablecoin (291 percent), the impermanent loss is also minimal (-4 percent ).
When the relative price change between Token 1 and stablecoin (483 percent) is significantly greater than the relative price change between Token 2 and stablecoin (8%), the temporary loss becomes notably larger (-50 percent ).
The ideal strategy is to use single-sided liquidity pools.
While the unequal liquidity pool and multi-asset pool both contribute to the reduction of temporary loss from the LP position, they do not totally remove it. If investors are concerned about impermanent loss, there are further DeFi protocols that enable investors to give only one side of the liquidity via a single-sided liquidity pool.
One can reasonably inquire as to where the risk of temporary loss is moved if investors do not bear it. Tokemak’s approach is to absorb this risk by utilizing the protocol’s native token, TOKE. Investors need merely to offer liquidity in the form of Ether on one side, while TOKE holders give TOKE on the other to pair with Ether to form the ETH-TOKE pool. Any temporary loss incurred as a result of Ether’s price change relative to TOKE will be absorbed by the TOKE holder. In exchange, TOKE holders receive 100% of the swap fees paid by the LP pool.
Due to the fact that TOKE holders also have the ability to vote on the next five pools to which liquidity will be routed, they are bribed by protocols to vote for their liquidity pools. Finally, TOKE holders bear the pool’s temporary loss and are rewarded in TOKE via exchange fees and bribe rewards.
Another option is to segment risks into distinct tranches, protecting risk-averse investors from impermanent loss while compensating risk-seeking investors with a high-yield product. Ondo, for example, offers a senior fixed tranche that mitigates impermanent loss and a variable tranche that absorbs impermanent loss but offers larger yields.
A fully automated limited partnership manager can alleviate investors’ concerns.
If all of the above appears too hard, investors can still employ the more usual 50/50 equal-ratio pool and an automatic limited partnership manager to actively manage and constantly rebalance the limited partnership position. This is particularly advantageous in Uniswap v3, because investors must select a range within which they wish to supply concentrated liquidity.
By charging a management fee, automated limited partnership managers execute rebalancing tactics to assist investors in maximizing limited partnership fees and minimizing temporary loss. There are two primary rebalancing strategies: passive and active rebalancing. The distinction is that active rebalancing swaps tokens to accomplish the required quantity at the time of rebalancing, but passive rebalancing does not and swaps tokens gradually until the token’s pre-set price is reached (similar to a limit order).
In a volatile market where prices are continually moving sideways, a passive rebalancing technique is advantageous since it eliminates the need for regular rebalancing and the associated high exchange fees. However, in a trending market when prices continue to move in one direction, active rebalancing is superior to passive rebalancing since the passive rebalancing approach may miss the boat and remain outside the LP range for an extended period of time, resulting in a loss of LP fees.
To choose the best automated limited partnership management, investors must choose their risk tolerance. There are passive rebalancing methods, such as Charm Finance, that seek a consistent return by utilizing a broad LP range to mitigate temporary loss. Additionally, there are passive managers such as Visor Finance that employ a relatively limited LP range in order to make high LP fees but are also more susceptible to temporary loss. Investors must choose automated limited partnership managers based on their risk tolerance and long-term investment objectives.
Although standard equal-ratio LP returns may be degraded by impermanent loss when the underlying tokens move in wildly divergent ways, investors have the option of reducing or totally avoiding transitory loss through alternate products and tactics. Investors only need to strike the optimal risk-reward trade-off to determine the optimal LP strategy.
Disclaimer: These are the writer’s opinions and should not be considered investment advice. Readers should do their own research.