An impermanent loss challenges the claim that DeFi is “the future of France”

Impermanent loss is one of the most recognized risks investors face when providing liquidity to an automated market maker (AMM) in the de...


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) space. Although this is not an actual loss incurred by the liquidity provider (LP) position – rather an opportunity cost that occurs compared to simply buying and holding the same assets – the possibility of recovering less value on withdrawal is enough to drive many investors away from DeFi.

The impermanent loss is driven by the volatility between the two assets in the equal ratio pool – the higher or lower one asset is relative to the other asset, the greater the impermanent loss is incurred. Providing liquidity to stablecoins, or simply avoiding volatile asset pairs, is an easy way to reduce impermanent losses. However, the returns from these strategies might not be as attractive.

So the question is: Are there ways to participate in a high-yield LP pool and at the same time reduce impermanent losses as much as possible?

Fortunately for retail investors, the answer is yes, as new innovations continue to address existing issues in the DeFi world, providing plenty of ways for traders to avoid impermanent losses.

Uneven liquidity pools help reduce impermanent losses

When talking about impermanent loss, people often refer to the traditional pool of two assets with an equal 50%/50% ratio – that is, investors must provide liquidity to two assets at the same value. As DeFi protocols evolve, unequal liquidity pools have come into play to help reduce impermanent losses.

As the chart below shows, the magnitude of the decline of an equal ratio pool is much greater than an unequal pool. Given the same relative price change – for example, Ether (ETH) increases or decreases by 10% against USD Coin (USDC) — the more unequal the ratio of the two assets, the smaller the temporary loss.

Temporary loss of even and unequal liquidity pools. Source: Elaine Hu

DeFi protocols such as Balancer have made uneven pools of liquidity available from the start of 2021. Investors can explore a variety of uneven pools to search for the best option.

Multi-asset liquidity pools are a step forward

Besides uneven cash pools, multi-asset cash 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 equal ratio triple pool USDC-WBTC-USDT has an impermanent loss lower than that of the USDC-WBTC equal ratio pool, as shown below.

Two-asset or three-asset liquidity pool. Source: Topaz.blue/Banking

Similar to the two-asset liquidity pool, the more the assets are correlated in the multi-asset pool, the greater the impermanent loss, and vice versa. The 3D charts below display the impermanent loss in a tri-pool given different levels of price change of token 1 and token 2 against the stablecoin, assuming a stablecoin is in the pool.

When the relative price change of token 1 against the stablecoin (294%) is very close to the relative price change of token 2 (291%), the impermanent loss is also small (-4%).

Simulation of impermanent loss of a tri-pool. Source: Elaine Hu

When the relative price change of token 1 in stablecoin (483%) is very different and far removed from the relative price change of token 2 in stablecoin (8%), the impermanent loss becomes significantly larger (-50%).

Simulation of impermanent loss of a tri-pool. Source: Elaine Hu

Unilateral liquidity pools are the best option

Although the uneven cash pool and the multi-asset pool both help to reduce temporary losses from the LP position, they do not eliminate them completely. If investors don’t want to worry about impermanent losses at all, there are also other DeFi protocols that allow investors to provide only one side of liquidity through a one-sided liquidity pool.

One wonders where the risk of temporary loss is transferred if investors do not bear the risk. A solution provided by Tokemak consists in using the native token of the protocol, TOKE, to absorb this risk. Investors only need to provide liquidity such as Ether on one side, and TOKE holders will provide TOKE on the other side to partner with Ether to create the ETH-TOKE pool. Any impermanent loss caused by Ether price movements against the TOKE will be absorbed by the TOKE holder. In return, TOKE holders take all swap fees from the LP pool.

Since TOKE holders also have the power to vote for the next five pools to which liquidity will be directed, they are also being bribed by protocols who want them to vote for their liquidity pools. Ultimately, TOKE holders bear the impermanent loss of the pool and are compensated by exchange fees and TOKE kickbacks.

Another solution is to separate the risks into different tranches so that risk-averse investors are protected against temporary losses and risk-seeking investors who bear the risk are rewarded with a high-yield product. Protocols such as Ondo offer a senior fixed tranche where temporary losses are mitigated and a variable tranche where temporary losses are absorbed but higher returns are offered.

Automated LP manager can reduce investor headaches

If all of the above seems too complicated, investors can always stick with 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 particularly useful in Uniswap v3, where investors must specify a range at which they wish to provide concentrated liquidity.

Automated LP managers conduct rebalancing strategies to help investors maximize LP fees and minimize impermanent losses by charging management fees. There are two main strategies: passive rebalancing and active rebalancing. The difference is that the active rebalancing method trades the tokens to reach the required amount at the time of rebalancing, while the passive rebalancing does not and only trades gradually when the predefined 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 there is no need to rebalance frequently and pay large swap fees. But in a trending market where the price continues to move in one direction, active rebalancing works best because the passive rebalancing strategy might miss the mark and stay outside the LP range for a long time and not collect the LP fee.

To choose the right automated LP manager, investors need to find one that suits their risk appetite. There are passive rebalancing strategies such as Charm Finance that aim to achieve a stable return by using a wide range of LP to reduce impermanent losses. There are also passive managers such as Visor Finance that use a very narrow LP range to earn high LP fees, but are also exposed to more potential impermanent losses. 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 profits can be eroded by an impermanent loss when the underlying tokens move in very different directions, there are alternative products and strategies available to investors to reduce or completely avoid impermanent losses. Investors simply need to find the right trade-off between risk and return to find the most suitable LP strategy.

The views and opinions expressed herein 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 conduct your own research when making a decision.