The fickle loss is one of the most well-known risks that investors face when providing liquidity to an automated market maker (AMM) in the decentralized finance (DeFi) sector. While it’s not an actual loss from the liquidity provider (LP) position – more of an opportunity cost incurred compared to simply buying and holding the same assets – the possibility of getting less value back on withdrawal is enough to convince many investors discourage from DeFi.
The temporary loss is caused by the volatility between the two assets in the equally-proportioned pool – the more one asset moves up or down relative to the other asset, the greater the temporary loss. Providing liquidity for stablecoins or avoiding volatile asset pairs is an easy way to reduce temporary losses. However, the returns from these strategies may not be as attractive.
So the question is: are there ways to participate in a high-yield LP pool while reducing as many fickle losses as possible?
Luckily for retail investors, the answer is yes, as new innovations continue to solve the existing problems in the DeFi world and offer traders plenty of opportunities to avoid fickle losses.
Uneven liquidity pools help reduce temporary losses
When it comes to temporary losses, people often refer to the traditional 50%/50% pool with two assets at equal ratios – meaning investors need to provide liquidity to two assets of equal value. As DeFi protocols have evolved, uneven liquidity pools have come into the picture to help reduce temporary losses.
As illustrated in the chart below, the downside potential of an even ratio pool is much greater than an uneven pool. With the same relative price change – e.g. B. Ether (ETH) rises or falls by 10% compared to USD Coin (USDC) – the more uneven the ratio of the two assets, the smaller the temporary loss.
Temporary loss from even and uneven liquidity pools. Source: Elaine Hu
DeFi protocols like Balancer have been providing unequal pools of liquidity since early 2021. Investors can explore a variety of disparate pools to find the best option.
Multi-asset liquidity pools are a step forward
In addition to uneven liquidity pools, multi-asset liquidity pools can also help reduce temporary losses. By simply adding more assets to the pool, the diversification effects come into play. For example, given the same price action in Wrapped Bitcoin (WBTC), the USDC-WBTC-USDT Equal Ratio Tri-Pool has less volatile loss than the USDC-WBTC Equal-Ratio Pool, as shown below.
Liquidity pool of two or three assets. Source: Topaze.blue/Bancor
Similar to the two-asset liquidity pool, the more correlated the assets in the multi-asset pool are, the greater the temporary loss and vice versa. The 3D graphs below show the volatile loss in a tri-pool at different levels of price change of token 1 and token 2 relative to the stablecoin, assuming there is a stablecoin in the pool.
If the relative price change of token 1 to the stablecoin (294%) is very close to the relative price change of token 2 (291%), the temporary loss is also small (-4%).
Simulation of an inconsistent loss from a tri-pool. Source: Elaine Hu
When the relative price change of token 1 to stablecoin (483%) is very different and far from the relative price change of token 2 to stablecoin (8%), the impermanent loss becomes noticeably larger (-50%).
Simulation of an inconsistent loss from a tri-pool. Source: Elaine Hu
Unilateral liquidity pools are the best option
Although the uneven liquidity pool and the multi-asset pool both help reduce the temporary loss from the LP position, they do not eliminate it completely. If investors don’t want to worry about fickle losses at all, there are also other DeFi protocols that allow investors to provide just one side of liquidity through a unilateral liquidity pool.
One might wonder where the risk of a temporary loss is transferred to if investors don’t bear the risk. One solution provided by Tokemak is to use the protocol’s native token, TOKE, to absorb this risk. Investors only need to provide liquidity like Ether on one side, and TOKE holders will provide TOKE on the other side to pair with Ether to form the ETH TOKE pool. Any temporary loss caused by the price movements of Ether relative to TOKE will be borne by the TOKE holder. In return, TOKE holders take all swap fees from the LP pool.
Since TOKE holders also have the power to vote for the next five pools that liquidity will be channeled into, they are also bribed by protocols who want them to vote for their liquidity pools. In the end, the TOKE holders bear the temporary loss from the pool and are compensated by the swap fees and bribe premiums in TOKE.
Another solution is to split risk into different tranches so that risk-averse investors are protected from volatile losses and risk-takers who bear the risk are rewarded with a high-return product. Protocols like Ondo offer a senior fixed tranche that absorbs temporary losses and a floating tranche that absorbs temporary losses but offers higher yields.
The automated LP manager can reduce investor headaches
If all of this seems overly complicated, investors can still stick to the most common 50%/50% equal ratio pool and use an automated LP manager to actively manage and dynamically rebalance LP position. This is particularly useful in Uniswap v3, where investors must specify an area for which they wish to provide concentrated liquidity.
Automated LP managers run rebalancing strategies to help investors maximize LP fees and minimize temporary losses by charging a management fee. There are two main strategies: passive rebalancing and active rebalancing. The difference is that the active rebalancing method exchanges tokens to reach the amount required at the time of rebalancing, while the passive rebalancing does not and only gradually exchanges when the preset price of the token is reached (similar to a limit Order).
In a volatile market where prices are constantly moving sideways, a passive rebalancing strategy works well because it doesn’t require frequent rebalancing and doesn’t involve paying large amounts in swap fees. But in a trending market where the price keeps moving in one direction, active rebalancing works better as the passive rebalancing strategy could miss the boat and sit outside the LP range for a long time and not collect LP fees.
To choose the right automated LP manager, investors need to find the one that matches their risk appetite. There are passive rebalancing strategies like Charm Finance that aim to generate a stable return by using a wide range of LP to reduce fickle losses. There are also passive managers like Visor Finance that use a very tight LP spread to earn high LP fees but also face a larger potential temporary loss. Investors need to choose automated LP managers based not only on their risk tolerance but also on their long-term investment goals.
Although traditional LP gains in the same ratio could be undermined by choppy losses when the underlying tokens move in wildly different directions, alternative products and strategies are available for investors to reduce or avoid choppy losses altogether. Investors just need to find the right trade-off between risk and return to find the most suitable LP strategy.
Readers interested in learning more about impermanent loss and how to avoid it can check out this brief explanation from the author.
The views and opinions expressed herein are solely those of the author and do not necessarily reflect the views of Cointelegraph.com. Every investment and trading move involves risk, you should do your own research when making a decision.
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