Impermanent Loss
Diatomix Basics
Decentralized exchanges (DEXs) are a promising application of smart contracts and blockchain technology that allows for peer-to-peer trading of assets without the need for a centralized intermediary. Centralized exchanges (CEXs) with an order book model provide deep liquidity and convenience, but have issues with centralization and vulnerability to hacking and government blockages. DEXs with an order book model address the centralization problem, but have market matching issues due to less liquidity. DEXs with an automated market maker (AMM) model solve market matching issues with peer-to-contract market making, but come with another problem of impermanent loss. An example of this is when a liquidity provider (LP) provides liquidity into the AMM for only one token, and tech-savvy arbitrageurs take advantage of the difference in pool price and market price to make a profit. This results in a theoretical loss for the LPs, which can become a permanent loss if they withdraw their tokens at this time. However, LPs can choose to wait for a market correction instead.
Strategies to avoid Impermanent loss
Stablecoin Pairs
When providing liquidity to a decentralized exchange, one way to avoid the problem of impermanent loss is to choose stablecoin pairs, such as USDT/USDC, as these prices are generally stable. However, this approach means that you will not benefit from any rise in the market value of the assets. The decision on whether to take on more risk in a bull market or opt for stablecoin pairs in a bear market depends on how much risk the liquidity provider is willing to tolerate. Ultimately, it is a trade-off between potential profits and potential losses.
Trading fees
When trading on a decentralized exchange, traders must pay a trading fee, a portion of which is passed on to liquidity providers as an incentive for providing liquidity. These fees can sometimes offset any impermanent loss experienced during liquidity provision. However, when using Uniswap v3, it is important to be mindful of the price ranges set when opening a position, as narrower ranges can lead to higher fees but also increase the risk of the asset price shifting outside of that range, resulting in no fees being earned.
Uniswap has some great resources for understanding concentrated liquidity here.
Low Volatility Pairs
When providing liquidity to a cryptocurrency pair, it is important to consider the volatility of the assets. For example, if one asset is expected to perform better than the other in the short-term, it may not be a good idea to provide liquidity to that pair. Instead, you could leverage your liquidity position to borrow stablecoins and swap to the token you think will perform the best to hedge against impermanent loss. However, if both assets are expected to rise or fall in relation to each other, providing liquidity to that pair would be less risky as the difference in performance would be lower. Overall, it is important to stay aware of the volatility of currencies by monitoring their current performance and future predictions.
Lending protocols
Lending protocols like Themis can be used to protect against losses that can occur when providing liquidity to a token pair on Uniswap. For example, if you’re worried that the price of ETH will go up before you’re able to withdraw your investment, you can use Themis to borrow more ETH in addition to your original investment in Uniswap. This allows you to continue earning yield on your initial investment while also holding onto the asset you think may increase in value. Users can borrow up to 65% of the value of their position, paid out in either ETH or a stablecoin.
Conclusion
To Summarize, Centralized exchanges (CEX) with order book models lack decentralization but have no liquidity issues. Decentralized exchanges (DEX) with order book models solve the centralization problem but struggle with market matching due to lower liquidity. Decentralized exchanges with automated market making (AMM) models solve market matching issues through peer-to-contract market making, but may result in impermanent loss.
Please find below, the links to other articles as part of Diatomix,
