Impermanent Loss
Context[edit]
Automated market makers (AMMs) are computer programs that replace the work of market makers within Decentralized Finance. They are in fact at the heart of Decentralized protocols since they lock tens of billions of dollars in total value and these emerging financial models are gaining in popularity over time.[1] The AMMs are at the core of any decentralized exchange. As the founder of Ethereum Vitalik Buterin cited, in this type of exchange, no registration or signing-in process is needed and people can transfer money to wallets and define output addresses with no need of any intermediary.[2] In this case, exchanges only represent an input-output channel, responsible for the transfer of tokens from one signed public address to another one in different currencies.[3] What is, in the roots, different compared to traditional market makers, is that the order book is here substituted by liquidity pools (LPs). These LPs allow people to exchange one token with another one, in a completely decentralized way, while keeping control over the deposited funds. There exist many decentralized exchanges that will let you provide liquidity to their pools and investors who deposit funds (Liquidity Providers) are motivated to contribute to the liquidity of a pool since they benefit from a portion of the transaction fees generated by the exchanges. The transaction fees vary from a DEX to another, for instance, on Uniswap V2 the fees constitute 0.3% of the transaction while on Sushiswap they represent 0.25% of the transaction.[4] Some AMMs such as Sushiswap also propose rewards for their liquidity providers encouraging them to invest in their pools. [5] The main limit of those AMMs is the suffering of impermanent losses.[6]
Definition[edit]
Impermanent loss is represented as the temporary loss of money that occurs as a consequence of providing liquidity in an AMM pool versus keeping the assets untouched in the wallet. We often observe this phenomenon making a large impact in liquidity pools where assets have to be provided at the same ratio and one of them is volatile with respect to the other. For example, the 50/50 Ethereum – Dai pool on Uniswap.[7]
In fact, AMM pools do not have true indicators regarding the price of an asset on another centralized or decentralized exchange. Arbitrage is then practiced by arbitrageurs who are agents that will benefit from price discrepancies throughout the market and keep the prices of AMMs UpToDate with the rest of the market. The money arbitrageurs win is the money liquidity providers lose. The opposite situation does not occur since the arbitrageurs would only trade if they are winning, making liquidity providers experience a loss they wouldn’t have suffered had they kept their tokens in their wallets.[8] It is called “Impermanent” since this loss counts as null in the case where the tokens of the pool return to their original values at the time the Liquidity provider invested in. However, in reality, this is very improbable, and liquidity providers end up incurring significant losses that remain, in fact, “permanent”.[9] This concept, being a major inconvenience for liquidity providers[10], lead to the emergence of tools and platforms that have as a purpose the analysis and domestication of impermanent loss.
Example[edit]
Set-up: A 50/50 AMM Pair having a 0.30% fee level (e.g. Uniswap) TokenA trades at 1000 TokenB on the AMM and on the outside market (a centralized exchange for instance) Price on the market suddenly moves at 1200 TokenB for 1 TokenA Arbitrageurs intervene and trade against the AMM by buying TokenA at a price starting at 1000 TokenB until reaching slightly less than 1200 TokenB for 1 tokenA (because of the trading fee). The Arbitrageurs effectively bought their TokenA at about 1100TokenB from the Liquidity providers - pocketing in value 100TokenB for each TokenA they bought after having paid around 3 TokenB of fees. Despite the trading fee, the LP position is now worth less than the equivalent portfolio held in private custody. Contrary to its name, Impermanent Losses are persistent in nature. These losses stack up and may constitute a significant drag on portfolio returns if left unchecked.[8]
References[edit]
- ↑ "DefiPulse". defipulse.com.
- ↑ Buterin Vitalik, TechCrunch Sessions: Blockchain, 2018.
- ↑ Dillet, Romain. "Vitalik Buterin: "I definitely hope centralized exchanges go burn in hell as much as possible"". techcrunch.com. TechCrunch.
- ↑ Prasanna, Prasanna (26 November 2020). "Uniswap vs Sushiswap: The Definitive DEX Comparison". cryptoticker.com. Cryptoticker.
- ↑ Mullaney, Ronan (21 January 2021). "SushiSwap yield farming rewards". minedhash.com. minedhash.
- ↑ Genie, BowTied (25 August 2021). "Part 1: Introduction to Automatic Market Makers and Liquidity Pools". medium.com. Medium.
- ↑ jakub. "What is Impermanent Loss? DEFI Explained". finematics.com. finematics.
- ↑ 8.0 8.1 Genie, BowTied (19 August 2021). "Part 2: Impermanent Loss". medium.com. Medium.
- ↑ Hindman, Nate (25 July 2021). "Beginner's Guide to (Getting Rekt by) Impermanent Loss". blog.bancor.network. Bancor.
- ↑ Boueri, Nassib (2021). "G3M Impermanent Loss Dynamics". Arxiv:2108.06593 [Q-Fin]. arXiv:2108.06593.
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