According to a recent study published by Paradigm, liquidity providers are much better at providing liquidity to AMMs similar to Uniswap than holding these tokens outside the pool. In other words, the profits generated by passive market making far exceed the impermanent losses faced by liquidity providers.
Paradigm claims that even if all incoming transactions are arbitrage, LPs (liquidity providers) tend to outperform HODLers (coin holders). This is due to the so-called volatility profit, or rebalancing premium.
“Volatility gains”: Under certain conditions, by periodically rebalancing two assets, they may outperform any static portfolio. In this case, “rebalancing” refers to trading so that the proportion of the total portfolio value held in each asset is returned to a fixed configuration, such as 50/50.
In other words, the systematic rebalancing of the portfolio often produces additional returns because it helps to manage volatility and avoid the concentration of the portfolio on one asset.
- From market making to portfolio management
The combination of passive portfolio management and market making is mainly promoted by the Balancer team. In Balancer, liquidity providers (portfolio managers) can store up to 8 tokens with predefined weights in the pool for doing so City and enjoy free automatic rebalancing to make profits from it.
Nonetheless, Paradigm focuses on Uniswap LPs (liquidity providers) and believes that Uniswap is a non-custodial portfolio manager. Over time, the company maintains a 50:50 exposure to the assets in the asset pool. Although it provides a new perspective on the role of Uniswap, the research is only theoretical. Actual market conditions will ultimately dominate the profit and loss of liquidity providers. Therefore, the next step of empirical experiments (combined with actual market conditions) is necessary.
In short, market making is not a risk-free behavior. Under adverse circumstances, liquidity providers will eventually suffer losses. More details on the adverse market conditions and consequences of liquidity providers can be found in our recent research.
