Understanding Impermanent Loss

One of the key innovations in the DeFi space is automated market makers (AMMs), and Uniswap remains the most prominent player in this domain. With the introduction of concentrated liquidity provisioning by Uniswap v3, users have the ability to provide liquidity in a more concentrated manner. However, liquidity provision comes with its own set of risks, with impermanent losses being a critical one.

We’ll delve into the concept of impermanent loss, its implications, and provide a few examples to illustrate its impact on liquidity providers (LP).

Impermanent loss is a phenomenon that affects LPs in AMMs when the relative prices of the assets in the liquidity pool change (without loss protection such as hedging, LPs are technically holding long positions on pool assets). This loss occurs when the value of assets held in the liquidity pool diverges from what would have been obtained by simply holding the assets. The term “impermanent” is used because the loss is not permanent (yet); it only becomes realized when LPs withdraw their funds from the pool, or when rebalance occurs.

In Uniswap v3, impermanent loss is particularly relevant due to the introduction of concentrated liquidity ranges (or price ranges). Unlike Uniswap v2, where LPs deposited assets across the entire price spectrum, Uniswap v3 allows users to concentrate their liquidity within a specific price range. While this feature offers more control and capital efficiency (more fees earned), it still exposes LPs to impermanent loss. It is the law of the markets that is impossible to change, but their impact can be mitigated.

Examples of Impermanent Loss (IL)

Suppose a scenario as below:

1. Initial Deposit in a Liquidity Pool: LP deposits equal values of ETH and USDC into a liquidity pool. The price range for this pool is set between $2000 to $2500 per ETH.
2. Price Movement of ETH: Subsequently, the price of ETH increases to $3000.

Resulting Impermanent Loss:

• Change in Asset Balance: Due to the price increase, the pool’s mechanism adjusts the holdings to maintain a balance, resulting in the pool holding less ETH and more USDC than at the initial deposit. This is because, in an AMM system, the pool must always maintain a certain ratio of assets. As the price of ETH increases, some ETH is sold for USDC to keep this ratio.
• Value Changes: The value of ETH in the pool increases due to its price rise, while the value of USDC remains relatively stable. This discrepancy leads to impermanent loss, where the combined value of the assets in the pool is less than if the LP had just held onto their ETH and USDC separately.
• Price Range and Fees: Since the ETH price has exceeded the upper limit of the designated price range ($2500 in this case), the LP’s position becomes inactive in terms of generating fees. In range-bound liquidity pools, LPs earn transaction fees only when the traded asset’s price is within their specified range. When the price falls outside this range, the position does not accrue fees, leading to an opportunity cost for the LP.

At this point, you should conclude that LP will always experience impermanent losses when asset prices diverge, especially in volatile markets or with assets that have a significant price fluctuation. It’s important to note that the loss is “impermanent” because it can be recovered if the asset prices return to their original state when the liquidity was first provided. However, if the LP decides to withdraw their funds while the price is outside the initial range, the loss becomes permanent.

On the other hand, stable liquidity pools with high correlation trading pairs should experience minimal and/or almost negligible impermanent losses due to the low probability of price divergence. For example:

• USDT-USDC, where both are stablecoins priced at $1
• wstETH-ETH, where wstETH being liquid staked ETH and follows closely to ETH
• BTC-ETH, where correlation stays above 0.8 frequently

Can we mitigate Impermanent Loss?

While impermanent loss is inherent to providing liquidity in AMMs, various strategies and tools can help users minimize the impact of impermanent loss and optimize their returns. We will focus on Parallax’s Concentrated Active Liquidity Management (CALM) features as an effective solution.

1. Automated Price Range Adjustment: CALM algorithmically selects and adjusts the price ranges based on changing market conditions. This proactive approach allows LPs to capture more trading fees and minimize exposure to impermanent loss during periods of high volatility.
2. Automated Rebalancing: Parallax implements and optimizes rebalancing triggers for each pool. Rebalancing involves periodically adjusting the allocation of assets in the liquidity pool to bring it back in line with the original desired ratios. Our automated rebalancing mechanisms can help mitigate impermanent losses by ensuring that the LP’s exposure to different assets remains within their predefined ranges.
3. Auto-Compounding of Fees: Every CALM vault comes with this feature, which involves continuous reinvesting the earned fees back into the liquidity pool, compounding the effects over time, and can significantly boost overall returns and offset potential impermanent losses.

Future strategies, like dynamic fee adjustments and incentive introductions, further aim to address impermanent losses and enhance LP returns.

In conclusion, understanding impermanent loss is crucial for DeFi participants, and thoughtful strategies, such as those provided by Parallax’s CALM, empower users to navigate the DeFi landscape confidently and maximize returns.

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