DEFI MARKET

"Dapp Pocket" provides liquidity may incur losses? Unraveling the myth of impermanent loss!

2020/11/18

Dear DeFi enthusiasts,

This week Bitcoin continues to surge, with the ETH 2.0 staking contract balance reaching 95,000 ETH. Many teams have also introduced low-threshold staking tools. Our focus this week is on DeFi, revisiting the most discussed "impermanent loss" in DeFi automated market makers.

Headlines this week include: DARMA Capital launches Ethereum staking product LiquidStake, allowing users to stake any amount of ETH and receive USDC loans; MakerDAO is set to introduce a rate stabilization module, add BAL and YFI as Dai collateral; and Aave releases V2 version on the testnet, and more.

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Key insights this week include Uniswap's Hayden Adams saying malicious attacks are not difficult at all!? Aave's Stani Kulechov questioning the government's stance on free competition!? And Bankless' Ryan Sean Adams opening Ethereum 101 classes!?

Table of Contents

Our Perspective

Providing Liquidity Could Lead to Losses? Demystifying Impermanent Loss!

With the emergence of automated market makers (AMMs) such as Uniswap and Balancer, the market has realized the significant fee income from providing liquidity to decentralized exchanges of this kind. However, many users hesitate to participate because they are aware of the existence of "impermanent loss," which may lead to unrecoverable losses. But is it really the case?

Understanding Automated Market Makers (AMM) First

To understand impermanent loss, we first need to know how AMMs generally operate. Taking Balancer as an example, liquidity providers (LP) can provide two or more different cryptocurrencies (e.g., Dai & ETH) to a liquidity pool and set the ratio between them (e.g., 50/50). At any given time, the trading price of tokens in the pool is determined by the quantity of tokens. For example, if the ratio of Dai quantity to ETH quantity in the pool is 450:1, anyone can buy or sell ETH for the price of 450. Balancer charges trading fees to traders and provides liquidity rewards to those who provide funds.

What is Impermanent Loss?

Impermanent loss, also known as impermanent loss, comes from the fact that AMMs like Balancer, which do not have the function of linking external data, rely on arbitrageurs in the market to rebalance the funds to keep the pool's token prices in line with the market. In simple terms, when the price of ETH rises to 500 Dai in the market, someone will notice that they can buy ETH for 450 in Balancer - buying one and earning one! They will actively buy ETH with Dai until the ratio in the pool is equivalent to the market price (Dai: ETH rising to 500:1).

So why does impermanent loss occur? The simplest explanation is that someone makes money through "arbitrage" in this pool - whose money is he making? The pool's! And whose money is in the pool? Of course, it's the liquidity providers. In other words, impermanent loss is "the loss incurred by liquidity providers due to the price difference between the pool and the market, taken advantage of by arbitrageurs."

How is Impermanent Loss Calculated?

There are many convenient impermanent loss calculators available online. For example, in a pool of Dai and WETH, if a LP deposits WETH and it rises from 380 to 460, an increase of 21%, the impermanent loss faced is 0.44%; if WETH doubles and rises by 100%, the impermanent loss increases to 5.57%.

Myth One: Misleading Terminology - Impermanent Loss vs. Unrecoverable Loss

Here, here, and also on this website, the term "compensation" was incorrectly used for "impermanent loss." Impermanent refers to "non-permanent" loss, which can be understood as a loss that may disappear in the long term and may not necessarily occur. Using the term "unrecoverable" can easily be misunderstood as a loss that is irreversible.

Myth Two: Impermanent Loss is Inevitable and Only Expands Once It Occurs

In reality, impermanent loss is only related to the instantaneous coin price difference when LP withdraws liquidity. For example, if an LP deposits Dai and WETH, and a year later WETH rises by 100%, withdrawing liquidity at that time would incur a 5.57% impermanent loss. However, if the LP continues to hold the position and a year later WETH falls by 50% or Dai rises by 100%, the impermanent loss when withdrawing liquidity at that time is 0%.

Conclusion: Should I Provide Liquidity?

The nature of AMM requires LPs to deposit two or more assets at once when providing liquidity. After selecting the cryptocurrencies you favor and finding a liquidity pool with decent trading fees and mining rewards, it's time to consider impermanent loss. As impermanent loss arises from price discrepancies, we can categorize pools into three types:

1. Cryptocurrencies with Statistically Positive Correlation, e.g., BTC and ETH BTC/ETH

If you plan to deposit mainstream cryptocurrencies like BTC and ETH for the long term, as their prices are generally positively correlated statistically, the impermanent loss ratio in the long run tends to be minor. We believe that depositing in a pool with high liquidity and decent interest in Balancer would be a stable way to profit.

2. Cryptocurrencies with Zero Correlation, e.g., Stablecoins and Non-Stablecoins Pool Dai/WETH

If you seek stability and deposit stablecoins with other coins, you can expect price discrepancies between the two to occur, and the longer you hold, the greater the price difference. In this case, you need to pay more attention to impermanent loss. If the pool's mining rewards are low, it may not be a good choice in the long run.

3. Cryptocurrencies with Almost Identical Price Trends, e.g., WETH/sETH Pool

If you are determined to avoid the risk of impermanent loss and still want to hold ETH, then the sETH/WETH pool is perfect for you! You can earn trading fees and liquidity mining rewards, and in the long run, these two tokens that are both anchored to ETH's price will hardly cause impermanent loss.

Weekly Highlights

✨ Top Headlines This Week

Ethereum 2.0 Deposit Contract Balance Exceeds 95,000 ETH

As of the time of writing this article, the Ethereum 2.0 deposit contract balance has exceeded 95,000 ETH, approximately 18.3% of the total required amount. There is still a considerable distance to the target of 524,000 ETH. At this pace, it seems challenging to launch on December 1st. If the launch on December 1st is not feasible, the 2.0 launch schedule will be postponed on a weekly basis until the staking amount is sufficient.

Aave Releases V2 Version on Kovan Testnet

DeFi lending protocol Aave announced the release of the Aave v2 version on the Ethereum Kovan testnet. This version features a new design architecture and upgrades to the protocol, UI, and UX, along with additional features and tools, including new collateral repayment options, reduced gas fees, optimized debt tokens, credit delegations, fixed-rate deposits, borrowing rates, and more.

MakerDAO Adds BAL and YFI as Collateral for Dai

MakerDAO has voted to add BAL and YFI as collateral assets for Dai. BAL is the ERC20 Token of automated market maker Balancer, and YFI is the ERC20 Token of decentralized yield aggregator Yearn.finance.

DARMA Capital Launches Ethereum Staking Product Allowing Users to Stake Any Amount of ETH and Receive USDC Loans

Cryptocurrency investment firm DARMA Capital has launched the Ethereum staking product LiquidStake. Users can stake ETH on LiquidStake, earn staking rewards, and receive USDC loans to maintain liquidity. DARMA Capital stated that they are long-term Hodlers of ETH, and this service would make Ethereum 2.0 more robust, benefiting their overall investment strategy.