Impermanent loss is one of the most recognized risks investors face when providing liquidity to an automated market maker (AMM) in the decentralized finance (DeFi) sector. Although not an actual loss incurred by the liquidity provider (LP) position, but rather an opportunity cost that occurs when compared to simply buying and holding the same assets, the possibility of recovering less value by withdrawing is enough to keep away to many investors. of DeFi.
The transient loss is driven by volatility between the two assets in the set of equal proportions: the more one asset moves up or down relative to the other asset, the greater the transient loss is incurred. Providing liquidity to stablecoins, or simply avoiding volatile asset pairs, is an easy way to reduce temporary losses. However, the returns of these strategies may not be as attractive.
So the question is: Are there ways to participate in a high-yielding LP pool while reducing as much transient loss as possible?
Fortunately for retail investors, the answer is yes, as new innovations continue to solve existing problems in the DeFi world, providing many ways for traders to avoid temporary losses.
Unequal liquidity pools help reduce temporary losses
When talking about non-permanent losses, people often refer to the traditional group of two assets with a 50%/50% equivalent ratio, that is, investors have to provide liquidity to two assets of the same value. As DeFi protocols evolve, uneven liquidity pools have entered the scene to help reduce temporary losses.
As shown in the graph below, the negative magnitude of a group of equal proportions is much greater than that of an unequal group. Given the same relative price change, for example, Ether (ETH) increases or decreases by 10% relative to USD Coin (USDC) — the more unequal the ratio of the two assets, the smaller the transitory loss.
DeFi protocols like Balancer have made uneven liquidity pools available since early 2021. Investors can explore a variety of uneven pools to search for the best fit.
Multi-asset liquidity funds are a step forward
In addition to uneven liquidity pools, multi-asset liquidity pools can also help reduce temporary losses. By simply adding more assets to the pool, diversification effects come into play. For example, given the same price movement in Wrapped Bitcoin (WBTC), the triple equal ratio pool USDC-WBTC-USDT has a lower temporary loss than the equal ratio pool USDC-WBTC, as shown below.
As in the two-asset liquidity pool, the more correlated the assets in the multi-asset pool are, the greater the non-permanent loss, and vice versa. The 3D charts below show the impermanent loss in a tri-pool given different price change levels of Token 1 and Token 2 relative to the stablecoin, assuming there is a stablecoin in the pool.
When the relative price change of Token 1 to the stablecoin (294%) is very close to the relative price change of Token 2 (291%), the impermanent loss is also low (-4%).
When the relative price change of Token 1 to stablecoin (483%) is very different and far from the relative price change of Token 2 to stablecoin (8%), the non-permanent loss becomes noticeably larger ( -fifty %).
Unilateral liquidity pools are the best option
Although the uneven liquidity pool and multi-asset pool help reduce temporary losses from the LP position, they do not completely eliminate them. If investors do not want to worry about temporary losses at all, there are also other DeFi protocols that allow investors to provide only one side of liquidity through a single-sided liquidity pool.
One might wonder where the risk of temporary loss is transferred if investors do not bear the risk. One solution provided by Tokemak is to use the protocol's native token, TOKE, to absorb this risk. Investors only need to provide liquidity as Ether on one side, and TOKE holders will provide TOKE on the other side to pair with Ether to create the ETH-TOKE pool. Any transient loss caused by price movements in Ether in relation to TOKE will be absorbed by the TOKE holder. In exchange, TOKE holders take all trading fees from the LP pool.
Since TOKE holders also have the power to vote for the next five pools that liquidity will go to, they are also bribed by protocols that want them to vote for their liquidity pools. In the end, TOKE holders bear the temporary loss of the pool and are compensated by redemption fees and bribe rewards in TOKE.
Another solution is to separate risks into different tranches so that risk-averse investors are protected from transient losses and risk-seeking investors who take the risk are compensated with a high-yield product. Protocols such as Ondo offer a senior fixed tranche where transient loss is mitigated and a variable tranche where transient loss is absorbed but higher yields are offered.
Automated LP Manager Can Reduce Investor Headaches
If all of the above seems too complicated, investors can still stick to the more common 50%/50% equal ratio pool and use an automated LP manager to actively manage and dynamically rebalance the LP position. This is especially useful in Uniswap v3, where investors must specify a range to which they wish to provide concentrated liquidity.
Automated LP managers carry out rebalancing strategies to help investors maximize LP fees and minimize temporary losses by charging a management fee. There are two main strategies: passive rebalancing and active rebalancing. The difference is that the active rebalancing method exchanges tokens to reach the required amount at the time of rebalancing, while the passive rebalancing does not and only gradually exchanges when the preset price of the token is reached (similar to a limit order). .
In a volatile market where prices are constantly moving sideways, a passive rebalancing strategy works well because you don't need to rebalance frequently and pay large amounts of trading fees. But in a trending market where the price keeps moving in one direction, active rebalancing works better because the passive rebalancing strategy could miss the boat and stay out of the LP range for a long time and not charge any LP fees.
To choose the right automated LP manager, investors need to find the one that suits their risk appetite. There are passive rebalancing strategies, such as Charm Finance, that aim to gain stable performance by using a wide range of LP to reduce temporary losses. There are also passive managers, like Visor Finance, who use a very narrow LP range to earn high LP fees, but are also exposed to a higher potential temporary loss. Investors should select automated LP managers based not only on their risk appetite but also on their long-term investment goals.
Although traditional equal-ratio LP gains could be eroded by temporary losses when the underlying tokens move in wildly different directions, there are alternative products and strategies available for investors to reduce or avoid temporary losses altogether. Investors just need to find the right tradeoff between risk and return to find the most suitable LP strategy.
The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph.com. Every investment and trading move involves risk, you should do your own research when making a decision.
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