Concentrated liquidity increases the risk of a temporary loss, Bancor and IntoTheBlock found

Update of on-chain markets from Into the block

Uniswap v3’s concentrated liquidity improved capital efficiency but also increased the risks of volatile losses.

Here’s the breakdown of liquidity provider profitability and how it could potentially be improved.

An interesting paper was recently published by the Bancor team relating to volatile losses in providing liquidity under the protocol. The study collected data from the launch of Uniswap v3 in May to the end of September. It concluded that the temporary losses (-$260.1 million) overshadowed trading fee income ($199.3 million). Furthermore, it found no evidence that certain very active management strategies would outperform these more passive strategies in rebalancing liquidity.

The methodology used for the study considered a total of 17 liquidity pools, which represented 47% of the platform’s TVL at the time. The rest of the TVL was not analyzed because it was in liquidity pools with stablecoins or coins that were price-pegged to each other, or in pools with insufficient liquidity (less than $10M). The data is divided into three main categories: positions, wallets and pools. This is useful as many wallets tend to deploy several different liquidity positions, on average 1.25 to 4 positions depending on the pool. This allows performance to be measured either by wallet or by position.

It also allows measuring which type of pools have suffered more fickle losses or accrued more fees, which can help learn how to mitigate fickle losses and minimize liquidity risk. Although gas charges are measured in the study, these conclusions were taken without taking them into account, so it would be expected that if they were taken into account, they would compound the losses.

Positions, wallets and pools

At IntoTheBlock we had access to the raw data from the study and were able to replicate the results. We were particularly interested in how the performance was per wallet and per position and how to compare them. In summary, 53.50% of positions were profitable versus 46.50% that were not. Looking at wallets, those that made profits are in the minority at 48.25% versus 51.75% that were unprofitable. So, as of the date of the study, we can conclude that the majority of addresses that provided liquidity in Uniswap v3 were not making any money.

The story goes on

The study goes deeper and analyzes the risk-adjusted returns of each position considered for the time they were active. After analyzing how active the positions are over different time periods, it can be seen that there have not been any periods when positions earned more fees than temporary losses, apart from flash liquidity providers. This is an advanced and complicated strategy known as just-in-time liquidity, which is performed by providing and removing liquidity in the same block where a large trade in the mempool is about to occur. Active management of liquidity thus does not outperform certain time periods compared to others.

The study also found that it’s common for wallets to have multiple different positions for the same pool, so it examined the performance of wallets by considering all of their positions and separating them by pool. Those pools that have the majority of addresses providing profitable liquidity are those that have high correlation (BTC-ETH, LINK-ETH, AXS-ETH, FTM-ETH).

Another oddly uncorrelated one is BTC-USDC. This is due to the high occupancy rate (fees/TVL). This highlights the importance of first considering the price correlations between assets, which minimize temporary losses, and then each pool’s utilization rates, which maximize returns. This is how certain pools achieve more fees than temporary loss, but they are the minority.

Lessons and Solutions

After analyzing the paper, we can conclude that providing concentrated liquidity is an activity with a higher risk but higher reward profile, more suitable for professional LPs and experienced DeFi users, similar to how market making is done (Liquidity by ranges is an abstraction related to central limit order books). Novice users looking to provide liquidity may find other protocols easier where the impact of a temporary loss is minimal or even non-existent. Being profitable in Uniswap v3 can be achieved by customizing how the user provides liquidity profitably, or by having the protocol mitigate some of those losses through design changes.

A user should always keep best practices in mind such as that pools with highly correlated assets will suffer significantly. Those who choose to use narrow range positions can expect higher returns, but at the cost of greater risk of incurring more volatile losses, and the time positions are held open doesn’t seem to have much effect. Certain pools can sometimes run the risk of having high utilization and trading fees overcoming temporary losses, even though they originally consist of uncorrelated assets.

Compare the temporary loss incurred relative to the price volatility between two assets

There are certain ideas from Uniswap v3 side that one could try to at least partially mitigate fickle losses for their users.

The most direct would be some sort of liquidity-removal scheme, offering UNI tokens in the popular pools, which are expected to have greater volatile loss due to their low correlation. Loss coverage with governance tokens can be implemented in the form of impermanent loss coverage or insurance for the positions that were really impacted (similar to Bancor). Another more adventurous endeavor would be to try the popular theme of protocol native liquidity (Tokemak, Olympus).

Do readers think this change would be feasible for an already deployed protocol with such a large TVL? Let us know.

Read the original post on The Defiant.

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