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25 May 2022
Why is it essential to consider Impermanent Loss before depositing assets into a liquidity pool?
This is going to be long, yet interesting. If you understand this concept well, you would open the pandora box of earning passive income from DeFi.
Recently, Liquidity Pools have become a lucrative source of earning passive income. A crypto-asset holder provides liquidity to a Decentralized Exchange (DEX) by depositing his assets to the Liquidity Pool. In exchange for that, DEX shares the trading fee collected from the trades with the Liquidity Providers (people who deposit their assets in the liquidity pool).
However, this process has an inherent risk of Impermanent Loss.
Now, let us understand what this risk is all about.
Impermanent loss is the loss to the liquidity providers of funds deposited to a liquidity pool.
It happens when the price at which assets were deposited to the pool changes. The more significant the change, the bigger will be the impermanent loss.
Although the term ‘Impermanent Loss’ is a bit misleading, it is called impermanent because the loss has not yet been realized by the liquidity provider. As soon as the liquidity provider withdraws the funds, the loss will be realized, and the said the impermanent loss would become permanent. In other words, the proportion in which a liquidity provider receives the assets is different from the ratio in which these assets were deposited by him in the liquidity pool.
Let us understand this from a different perspective. Suppose a person has some crypto assets. Now he has two options: he can deposit these funds in a liquidity pool or keep these funds with him in a wallet (HODL). Impermanent loss is the difference in the value of assets in these two scenarios.
We will understand this with the help of an example in a short while. But, first, let us understand the reason for the impermanent loss.
Centralized exchanges such as Binance and Coinbase usually have large order books that provide liquidity and determine the price of the assets on these exchanges. However, Decentralized Exchanges (DEXs) such as Uniswap and Sushiswap do not have order books like a centralized exchange. To ensure liquidity on the platform, these protocols have liquidity pools. Anyone can deposit funds to the pool and provide liquidity to the platform. In exchange for providing liquidity, the platform shares the exchange’s trading fee with the liquidity providers.
Because these exchanges do not have any order book, price of an asset is determined by an algorithm which considers ratio of the assets in the pool. This algorithm is known as Automated Market Maker (AMM).
The problem with this mechanism is that it keeps the platform isolated from the market situation. Therefore, the price of an asset on a DEX can be different from the rest of the market.
The price difference creates an opportunity for the arbitrageurs to earn arbitrage gain.
Who are arbitrageurs?
Arbitrageurs are people who identify and exploit price inefficiencies in the markets to make risk-free profits.
As in the above situation, an arbitrageur can simply purchase a crypto asset from one exchange and sell it on the other exchange. This is a risk-free profit-making mechanism.
However, the arbitrageurs help correct these price inefficiencies by bringing demand to the platforms where needed.
Let us understand this with the help of an example.
David is a crypto investor and has recently invested in BNB tokens. He wants to hold these assets for one month and would sell them the next month.
David is confused about whether he should hold these assets in his wallet or deposit these assets in a liquidity pool and earn some additional income (in the form of a DEX trading fee).
Let us try and help David make this decision.
Option 1 – David deposits these assets in a BNB/USDT pool on Uniswap.
Structure of a Liquidity Pool
A liquidity pool typically consists of 2 assets having equal weight in the pool. Equal weight means that the value of both the tokens in the pool is equal. For example, if the value of a BNB token is USD 400, then in a BNB/USDT pool, for every 1 BNB token, 400 USDT would be required to be deposit. This will maintain a 1:1 ratio of the value of both the tokens.
The AMM algorithm works in a way that this ratio is maintained at all times.
Suppose David has 10 BNB tokens to deposit in the pool. In order to deposit 10 BNB tokens to the BNB/USDT pool when price of 1 BNB is 400 USDT, David would need to deposit 4,000 USDT. So, David has deposited assets worth $8,000.
Option 2 -David keeps his assets worth $8,000 with him and HODL.
Now, focus on Option 1. Suppose a month later, the price of BNB increases by 25% to USDT 500 in the open market. The price on Uniswap would remain USDT 400 as this is not affected by the market.
This price inefficiency will create an opportunity for arbitrage gain till the time price of BNB on Uniswap is equal to the rest of the market. This means that arbitrageurs will purchase cheaper BNB from Uniswap and sell it on Binance. This process will keep changing the ratio of assets in the Liquidity Pool till the price of BNB is USDT 500.
Note: Uniswap allows trading of ERC-20 tokens only. BNB is taken just as an example.
After this process, the ratio of BNB and USDT in the pool would have changed. Therefore, David’s share in these assets would also have changed. When he withdraws his assets, the ratio of assets withdrawn will be different from the ratio in which they were deposited (i.e., 1:400).
When David withdraws his funds, he receives 8.75 BNB and 4,375 USDT. Thus, in Option 1, David deposits assets worth $8,000 and receives assets worth $ 8,750 after one month. Please note that the assets that will be available at the time of withdrawal can be calculated with the Impermanent Loss calculator. One such calculator can be referred here.
Let us compare this with Option 2, i.e., what would have been the value of assets if he had HODLed.
So, David had assets worth $8,000 as the initial investment. In Option 1, when he withdraws funds from liquidity pool, he has funds worth $8,750. However, when he just HODL, he would have assets worth $9,000. Thus, there is an Impermanent loss of $250 ($9,000 – $ 8,750).
It is worth noting that impermanent loss happens not only because of an increase in the price but also because of a decrease in the price. The more the percentage change in the price, the more prominent will be the impermanent loss. Therefore, the risk of impermanent loss is substantially less in case both the assets deposited into the pool are stablecoins.
Decentralized exchanges share a portion of the exchange’s trading fee with the liquidity provider. In most cases, the trading fee received by the liquidity provider from the exchange is more than the impermanent loss.
Further, exchanges also reward liquidity providers with their in-house tokens through liquidity mining. Thus, ultimately a liquidity provider should always be in a profit situation.
Therefore, in the above example, share of trading fee received by David would have been more than his Impermanent Loss. Therefore, ultimately, he would have gained by providing liquidity to the DEX.
However, it would be best to always consider the risk of impermanent loss before providing liquidity to any pool.
Impermanent loss happens when a pool consists of any volatile asset, and the weight of those assets is fixed, i.e., 1:1 in the above example.
Many protocols such as Balancer and Curve have tried to resolve impermanent loss by creating variable weights. However, they are only able to mitigate this risk to an extent.
On the other hand, Bancor has created variable weights which are impacted by the market price of the assets. These prices are incorporated into the chain with the help of Chainlink Oracle. And Voila! The risk of Impermanent loss is completely mitigated.
Still, many platforms yet expose their liquidity providers to the risk of impermanent loss. Therefore, every liquidity provider should understand this risk before depositing his assets into the Liquidity Pool.
1- Providing liquidity to stable coin pairs.
2- Avoiding risky and volatile cryptocurrency pairs.
3- Providing liquidity to pools with unevenly weighted cryptocurrencies.
4- Providing liquidity to incentivised pools and participating in liquidity mining programs.
5 – Provide liquidity to platform like Bancor, Thorchain that allows single side liquidity.
That depends upon your investment horizon, and the pair on which you providing liquidity. In some scenario it could be better than HODLing and in some cases impermanent loss could eat your profit, that you have made by simply Holding.