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With the development of the centralized liquidity model launched by Uniswap V3, we will see more discussions about impermanent loss management.
Original title: “Five strategies teach you how to avoid impermanence losses in DeFi”
Written by: William M. Peaster
Impermanent loss (Impermanent loss, also known as “non-permanent loss”), that is, the loss of value due to the provision of liquidity to automated market makers (AMMs), is the inherent risk of providing liquidity in DeFi. Understanding how to manage this phenomenon can enable liquidity providers (LPs) to better provide liquidity to AMMs. This article will outline some different strategies and teach you how to reduce or avoid impermanence losses during DeFi activities.
What is impermanence loss?
Decentralized exchanges (DEXs) in the DeFi ecosystem have created an automated market maker (AMM) model. AMMs are centered on liquidity pools, which are driven by liquidity providers (LPs), and these LPs provide (deposit) encrypted assets to these liquidity pools for anyone (trader) to trade through these liquidity pools .
What is the main idea? That is, traders can exchange the tokens they want through the liquidity pool at any time, and LPs can earn a part of the transaction fee when the tokens in the liquidity pool are used.
However, for many liquidity pools, it is far from guaranteed whether their LPs can profit from transaction fees within a certain period of time. This is because of the so-called impermanence loss: due to the basic nature of AMMs working methods and the volatility of cryptocurrencies, impermanence loss is a basic risk when providing assets to the liquidity pool.
Simply put, AMMs like Uniswap use special algorithms to automatically maintain the balance of the asset ratio of a liquidity pool, such as maintaining a 50/50 ratio of the value of these two assets in the ETH/WBTC pool, while the price of ETH and WBTC fluctuates This will lead to rebalancings of this proportion, in which case LPs will suffer a capital loss compared to their initial deposit.
The concept of liquidity pool, source: Finematics
This kind of loss is also called “non-permanent” loss, because the loss is permanent only when LPs withdraw their liquid funds when they are in an impermanent loss. For example, due to market fluctuations, your LP position in a certain liquidity pool may suffer an impermanent loss today, but tomorrow this impermanent loss will disappear again and again.
What is the easiest way to understand impermanence loss?
When the value of the LP position is lower than the value of these deposited tokens on the open market, impermanent losses occur. In other words, compared to depositing liquid assets in the ETH/WBTC pool on Uniswap, if you simply hold ETH and WBTC in your wallet to make more profit, then an impermanent loss occurs at this time.
An example of impermanence loss
If you still cannot understand impermanence loss, here is a simple example to help you understand.
Suppose you go to Uniswap and you want to provide 1,000 USD liquidity in the ETH/USDC pool. If the current ETH price is US$1,850 and the USDC price is US$1, and since you need to invest 500 US dollars in liquidity in each of these two assets, this means that you will eventually deposit about 0.27 ETH and about 500 into the pool. USDC.
Then let us assume that after a few weeks, the price of ETH has dropped to $1,400. At this time, your LP position rebalancing will make your position become 0.31 ETH and 434.96 USDC, with a total value of 869.92 USD. In comparison, if you simply held the initial 0.27 ETH and 500 USDC (rather than providing liquidity to Uniswap) at the beginning, then the total value of the two assets at this time is 878.38 US dollars, which is more than US$869.92 is more than US$8.50. In this hypothetical example, LP suffered an impermanence loss of less than 1% ($8.50/$1,000 = 0.85%).
If you are interested in the calculation of impermanence loss, you can consider using the Uniswap- centric impermanence loss calculator tool from dailydef.org.
Impermanence loss calculator
Strategies for mitigating impermanence losses
Now that we know what impermanence loss is, how can we fight it? In many liquidity pools, impermanence loss is an inevitable reality, but there must be a series of strategies that can be used to reduce or even completely avoid the impact of impermanence loss.
Here are some of the most basic strategies for mitigating impermanence losses.
Avoid high volatility liquidity pools
Cryptocurrency assets like ETH are not tied to the value of external assets like stablecoins, so their value will fluctuate with market demand.
It should be noted that the liquidity pool centered on volatile assets is the largest source of impermanent loss risk. Although encrypted blue chip stocks like ETH and WBTC may be more volatile, other small currencies face greater possibility of intraday price fluctuations, so from the perspective of impermanent losses, they are more risky.
If avoiding impermanence losses is the most important aspect for you, then a wise choice is to avoid providing liquidity to highly volatile liquidity pools.
Choose a liquidity pool that anchors the same asset
Stablecoins such as USDC and DAI are anchored to the value of the U.S. dollar, so these stablecoins are always traded at around 1 USD. Then there are other crypto assets that anchor the same asset, such as sETH and stETH anchored to ETH, WBTC and renBTC anchored to BTC, and so on.
In these liquidity pools that anchor the same asset (such as the USDC/DAI pool), the volatility between these tokens is small. This dynamic will naturally cause little or no impermanence loss to LPs. Therefore, if you want to become an LP and earn fees, but don’t want to face a large amount of impermanent losses, then choosing to provide liquidity to these liquidity pools anchored to the same asset is a good choice.
Provide liquidity to the pledge pool
In DeFi, not all LP opportunities come from the dual-token liquidity pool. In fact, for LPs, other popular sources of income are staking pools. Staking pools are usually used to guarantee the solvency of DeFi agreements (when facing insolvency), and staking pools only accept deposits. Into one type of asset.
For example, the pledge pool Stability Pool of the loan agreement Liquidity: Users provide LUSD stablecoins to the Stability Pool pool to ensure the solvency of the Liquidity agreement. In exchange, these LPs will receive a share of the income from the accumulated liquidation fees of the Liquidity agreement. There is no impermanence loss in such a pledge pool, because there is no rebalancing of the ratio between the two assets!
Choose a liquidity pool with an unbalanced asset ratio
A liquidity pool with an unbalanced asset ratio means that the asset value ratio in the pool is not a traditional 50/50 liquidity pool. Balancer is known for creating this flexible liquidity pool. The asset ratio in the liquidity pool on the platform can be 95/5, 80/20, 60/40, and so on.
These asset ratios will have an impact on impermanent losses. For example, based on the 80/20 AAVE/ETH pool, if the price of AAVE rises relative to the price of ETH, then most of the risk exposure of the LPs in the pool is AAVE (accounting for 80% of the pool), so The impact of impermanence caused by price fluctuations is less than that of LPs providing 50/50 liquidity for the AAVE/ETH pool.
Therefore, providing liquidity to such an imbalanced liquidity pool is also a way to alleviate impermanent losses, although it still depends entirely on the price performance of the underlying assets.
Participate in the liquidity mining plan
Today, liquid mining schemes (that is, agreements to distribute governance tokens to the original LPs) are ubiquitous in DeFi. why? Because liquidity mining provides these DeFi protocols with a simple way to decentralize protocol governance, attract liquidity, and win the hearts of early users.
However, participating in liquid mining has another advantage, that is, in many cases, the token rewards obtained by participating in liquid mining can make up for any impermanent losses faced by LPs. In fact, if the token reward you get in two months by participating in liquidity mining is equivalent to 25% -100% of the liquidity value you initially deposited, then you will suffer a 5% impermanence loss during this period It’s not worth mentioning.
At the very least, these token rewards can offset the impermanent losses that LP encounters. Therefore, as an LP, you must always keep in mind those liquidity pools that provide incentives.
to sum up
As AMMs become more and more popular, impermanence loss is a phenomenon that more and more people will have to deal with. The good news is that there are some feasible strategies to help you do this with the ability and discretion.
Looking to the future, the recent launch of Uniswap V3 introduced “centralized liquidity”, which allows LPs to provide liquidity in a specific price range, instead of having to accept liquidity in the entire price range (zero-positive infinity) as before. The method is at the forefront of the DeFi field. “Concentrated liquidity” amplifies the income and impermanence losses of LPs, so this is a new and more efficient LP model. As this centralized liquidity model continues to be further adopted, it is expected to see more discussions about impermanent loss management!