What is Impermanent Loss?
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The arrival of Web3 projects and DAOs has necessitated the creation of tools to streamline and manage treasury assets. This is needed to optimize business liquidity while mitigating financial, operational, and reputational risks. Understanding liquidity is critical to the success of any Web3 project.
Crypto economic systems require large reserves of cryptocurrencies to seamlessly enable individual trades. Liquidity is provided by users (known as Liquidity providers, or LPs) to create these reserves. A low transaction fee is applied to each transaction within the pool, which goes straight to liquidity providers as rewards for their deposits. These transaction fees are added to the pool, increasing its size and value while also boosting the value of the LP token.
In DeFi, pooling liquidity to create reserves for Automated Market Markers (AMM) is one of the strategies employed to enable users to trade their crypto assets on decentralized exchanges without the need for centralized market markers.
By locking one’s capital, which is usually paired with another asset, liquidity is provided, and as mentioned earlier, providers are rewarded with rewards generated from trading charges and also staked LP tokens. Committing assets to a liquidity pool brings rewards passively, but it also comes with a risk known as Impermanent Loss (IL), owing to the volatility between the pooled assets.
Crypto assets are volatile, let alone in a pool of two crypto assets paired together. The effects of the volatility will be more polarized in a liquidity pool of many assets due to the relative price change between the assets.
What is Impermanent Loss?
Impermanent loss refers to the temporary loss of value that liquidity providers may face as a result of price volatility in a trading pair when compared to how the value of the assets if one were to have simply held on to the assets.
This trading pair in a liquidity pool may be a stablecoin like DAI, while the other may be a more volatile cryptocurrency like ETH.
Reductively, let’s say a provider needs to supply comparable levels of liquidity in both DAI and ETH, but the price of ETH suddenly rises. Because the price of ETH in the liquidity pool is no longer in tandem with the price of ETH outside the liquidity pool atmosphere, an arbitrage opportunity is created, allowing other traders to buy ETH at a discounted cost until the ratio of DAI to ETH reaches equilibrium again, ensuring that the ratio of DAI to ETH remains balanced. This will make an LP end up with slightly more DAI and slightly less ETH. However, as the name suggests, this loss is impermanent and it is only when a provider decides to permanently remove their liquidity that the loss becomes permanent.
Mitigating Impermanent Loss
Impermanent loss is almost unavoidable due to crypto’s price volatility. However, there are ways to mitigate it:
- Provide liquidity into a stablecoin pool: Stablecoins are volatility-resistant and thus, the impermanent loss is not likely to happen in this scenario unless there is a de-pegging event.
- Provide liquidity in weighted pools: Protocols like Balancer or Beethoven-X offer the ability to provide liquidity into weighted investment pools that resemble index funds. Assets are split into the pool’s components based on pre-defined ratios that are actively maintained. The higher the weight of an asset, the lower the IL risk for it.
- LP rewards: Providing liquidity to a pool entitles the LP to trading fees and, in some instances, the protocol’s token. These returns are translated into the pool’s APY. The higher the APY, the lower the impact of impermanent loss.
- Single-sided staking: Innovative protocols like Bancor allow you to stake a single asset into a liquidity pool, protecting you from impermanent loss.
- Waiting; Allow for asset prices to the initial rate before withdrawing.
How Capital-as-a-Service (CaaS) Fits Into This
DAO data aggregator, DeepDao, indicates that DAOs hold over $10 billion worth of treasury assets. These assets require careful liquidity and risk management in order for these organizations to meet their operational objectives and grow. Liquidity provisioning is one of the ways for these DAOs to grow their treasury, meaning they will inevitably face impermanent loss. Yet, there are no automated tools to help manage these positions and mitigate other potential risks.
Through CaaS, you can offload these treasury management functions to a dedicated treasury management provider via a bespoke vault controlled by your own treasury that is supplemented by a monitoring dashboard and automated risk infrastructure. Work with Exponent so you can focus on building while having the runway to achieve your vision.
To learn more about Exponent, visit our website: https://exponent.cx/