Liquidity Pools and Impermanent Loss
Automated Market Maker (AMM) technology has taken off in recent years. The liquidity providers who provided liquidity to the Liquidity Pool (LP) may see that their staked tokens losing value in comparison to if they would have simply held their tokens.
The risk involved is known as “Impermanent loss” and due to this, a lot of traditional and institutional users have backed out from providing liquidity.
What is Impermanent loss?
Presented in a simple manner, the impermanent loss is the difference between holding tokens in your wallet vs holding it in a LP. If you provide liquidity to an LP and the value of token deviates from the external markets, the short-term loss which the liquidity pool suffers is known as impermanent loss.
It is known as impermanent because when the token’s relative price in the liquidity pool goes back to the original state while entering the AMM, the loss which occurred disappear and 100% of the trading fees are earned.
How does it Occur?
To fully understand the concept, one needs to get an idea of how AMM pricing works and what is the role of arbitrageurs.
When the value of tokens changes in external markets, and AMM cannot automatically adjust the price as they are disconnected from external markets. An arbitrageur is required. An arbitrageur is a person who buys the underpriced assets or sells the over-priced ones until the prices offered by the AMM match the outside market. The arbitrageurs makes a profit while creating an equilibrium between the price of the asset externally and internally. This profit comes from the pocket of liquidity providers, which results in an impermanent loss.
Impermanent Loss, a non-issue?
Let’s understand it through an example. We assume an AMM with two assets, DAI and ETH, balanced at a 50:50 ratio. When there is a change of price in ETH, it opens a big opportunity for arbitrageurs to make some profit.
1. First of all, the balancing is done for DAI/ETH with values that are equal on both sides.
2. The cost of ETH increases by 10% which creates an arbitrage opportunity. Now the arbitrageur can buy ETH at lower rates (10% cheaper) than the external market from AMM.
3. Now to create the equilibrium again the arbitrageurs are incentivized to balance the AMM by making a sale of DAI for ETH until both sides come in equilibrium.
4. Due to this, the liquidity providers suffer a — $2.38 loss compared to holding ETH and DAI.
The Centralised Financial Market
It is uncommon to observe such arbitrage opportunities in the centralised asset market because:
- Assets like stocks do not typically list on multiple exchanges,
- If assets do list on multiple platforms, like currencies, the prices and liquidity are synchronised across all platforms centrally
- Users do not need to put up liquidity for both sides of the paired-asset due to an abundance of liquidity.
The Centaur liquidity pool uses the Centaur Chain as a settlement layer to all the different liquidity pool hence allowing single-token liquidity provision which we will explain in more details in the next article of this educational series.
By combining the best elements of decentralised finance with measured regulatory control, Centaur is bridging DeFi and traditional finance. For more information, please take at a look at our website or join our Telegram community discussion group and announcement channel.
You can also go through our whitepaper or play around with our testnet block explorer and liquidity pool (Ethereum Ropsten).
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