Automated market makers (AMMs) like Uniswap, SushiSwap and Curve perform a vital role in decentralized finance (DeFi). Without them, DeFi users would be forced to use a centralized exchange to trade and, assuming their desired token is even listed, they would face reduced liquidity and high fees.
As we have covered in a previous YIELD blog, an AMM doesn’t use order books or any institutional market maker, so liquidity providers (LPs) are essential to their operation. Frictionless trading requires plenty of liquidity and, in DeFi, that liquidity often comes from mainstream users.
Yield farming, or liquidity mining, has become enormously popular over the past year. Instead of simply holding crypto coins and tokens, users can provide liquidity to a pool to make extra cash from trading fees, token rewards, and interest.
At first glance, this looks like a great opportunity for individual investors to trade assets: unfortunately, the reality is quite different. Smart contract exploits and transaction fees present some obvious risk to liquidity providers, but other dangers aren’t as conspicuous. In fact, the biggest hazard of all might be impermanent loss.
Users face impermanent loss when the price of a token changes after they have added two assets to a pool. These losses are called “impermanent” because they aren’t realized until the LP withdraws their tokens from the pool. Once liquidity is removed, the losses become permanent.
Known as “opportunity cost” in traditional finance, impermanent loss can occur both when a token price goes up and down, and is effectively the theoretical loss made by not holding or selling an asset. As a liquidity protocol relies on automatic price balancing, this is considered by many to be an inevitable side-effect of the nature of an AMM. Let’s take a look at an example:
Decentralized exchanges (DEXs) require LPs to supply an equal amount of each token to a trading pair in a liquidity pool (a ratio of 50:50). This means that if you want to provide $2,000 to the ETH-USDT pool, you’d need to deposit $1,000 in ETH and $1,000 in USDT, for instance.
The problem is that ETH has more price volatility than USDT, and Uniswap is constantly balancing the liquidity pool at 50:50. So, while ETH might double or even triple in value, USDT’s value will not move, effectively pegging the ETH you have deposited in the pool at $1,000.
In that case, simply holding onto the ETH you put in the pool would have been more profitable than providing liquidity to the pool.
Arbitrage, a necessary friend
It’s important to note that AMMs don’t use external sources like oracles to establish market prices. Instead, they rely on arbitrage traders to keep things balanced. If the price of ETH increases from $500 to $550, arbitrage traders will buy up ETH until it reaches an equilibrium with the rest of the market. These traders look for price discrepancies between two assets and use lots of capital to trade small price changes.
Arbitrageurs can make a nice profit by doing this, but it inherently hurts LPs, since Uniswap always maintains a 50:50 ratio for all liquidity pools. When the price of ETH goes up, USDT floods into the pool, and LPs will have less ETH and more USDT if they withdraw their assets from the exchange. Those losses compound when the price of one token drops dramatically or, even worse, when both tokens lose value.
Offsetting impermanent loss
A few strategies address how to deal with impermanent loss. When you provide liquidity to a stablecoin pool, you reduce the risk of volatile price swings. However, one has to wonder if the low interest on these pairs is worth the risk, especially if the assets aren’t insured by a third-party like Nexus Mutual. If someone is determined to be a market maker, they’ll have to weigh every option. Successful liquidity mining requires a formula, research, and strategy.
Another method is to earn enough through trading fees and liquidity mining to balance out the losses. The value of the token issued, how much is being minted per block (its “emission” rate), and the APY can vary dramatically from one protocol to the next. Liquidity pools balanced with more favorable ratios (such as 98:2 offered on Balancer) also reduce the impact of impermanent loss significantly.
Farms with too many pools or high APY often face supply hyperinflation and enter a “death spiral” in price. In other words, there’s too much selling pressure and not enough demand for the mined token. This means it’s a tricky, often impossible task to try to offset impermanent loss.
Finding a solution
Without a way of limiting impermanent loss, DeFi becomes decidedly less decentralized. It makes liquidity mining unviable and dangerous for most individual investors, consequently shutting the door on a huge and important sector of crypto. In many cases, we’re seeing the rich getting richer because the protocols favor high-capital actors with assets to burn. If DeFi wants to realize its aim of democratizing finance, it’ll need to be easier, more inclusive, and safer for the average user.
Decentralized exchanges are the most popular type of AMM and must play a leading role in finding a solution to impermanent loss. Undoubtedly, the first decentralized liquidity protocol to truly mitigate it on more volatile trading pairs will establish itself among the leading DEXs, but for now, it’s an irksome and inevitable byproduct of the ecosystem.