What is Impermanent Loss and How Slick Finance Helps You Avoid it?
What is Impermanent Loss?
Impermanent loss is defined as the difference between holding tokens in an AMM vs. holding tokens in your own wallet. Impermanent loss occurs when the price of a token inside an AMM changes in relation to the price at the time when token was deposited.
Confusing? Let’s simplify it:
To understand what impermanent loss is we need to first understand each participant in the De-Fi system and their role.
1. AMM — Automated Market Makers
These are essentially exchanges without an order book disconnected from external markets Usually, if the price of Ethereum moves on Binance it automatically gets adjusted on Coinbase. However, if token prices change on external markets, an AMM doesn’t automatically adjust its prices. (Then how does it happen? Read along)
The amount by which the price of the token falls/increases if a certain trade is taken. In AMMs traders can always make a transaction however each order impacts the price of the asset they are trading this is called slippage.
3. LPs — Liquidity Pools & — Liquidity providers
Liquidity Pools are essentially tokens locked in a smart contract, they typically provide liquidity in equal amounts of 2 tokens e.g., Ethereum & USDT.
Liquidity providers are people/entities who deposit equal amounts of 2 tokens to earn a commission on fees. AMMs rely on liquidity providers to ensure slippage is low. In return, liquidity providers obtain trading fees in the form of Liquidity Pools’ tokens.
Remember in Point 1 we said that in an AMM price doesn’t automatically adjust until someone comes along to buy the under-priced asset or sell the overpriced asset, to the extent that prices offered by the AMM match external markets. This is precisely what an arbitrageur does. Arbitrageurs, smart folks or smart programs written by smart folks, track the price of various assets across different markets, identify arbitrage opportunities (eg. price difference between Ethereum on Binance and Uniswap) and advantage of this opportunity.
5. Fair Market Price
The price of the benchmark tokens in the external market is considered the fair market price. This is where Arbitrageur comes in, he/she would typically match the AMMs token price to Fair Market Price extracting his/her profit in the process.
Now that we know the participants, let’s understand Impermanent Loss happen with an example:
- Liquidity providers (You) provide 50:50 liquidity to a liquidity pool in Uniswap. Essentially depositing 1 Ether (for this example consider Ether price $500) and $500 Worth USDT. All is good whilst the value of both sets of tokens remain same.
- However, Ether is not a stable-coin so it’s value is bound to change. Let’s say the price of ETH goes up to $550 on Coinbase.
- An Arbitrageur notices this price difference and decides to make a profit. The arbitrageur buys cheaper ETH on Uniswap until there is no more price discrepancy between the exchanges.
- However as the arbitrageur make this profit, the money is effectively ‘lost’ by liquidity providers, resulting in impermanent loss and this is how LPs feel:
- Now, let’s assume that the price of Ether were to drop back to $500 on Coinbase, the Arbitrageur would then sell Ether on Uniswap until Ether price at Uniswap also becomes $500. In this case, the LP would not realize thus any loss, thus loss incurred in Step 3 & 4 would become and remain ‘impermanent’ — but this hardly ever happens.
So in-short, Impermanent Loss has a large impact on Liquidity Providers’ profitability
- As long as the LPs don’t withdraw their liquidity the loss remains impermanent (it is just a fancy term for “unrealized”)
- If the value comes back to the original levels at which the LPs provided liquidity, the loss remains impermanent but that almost never happens in a dynamic market
- So the impermanent loss is effectively unrealized loss and is, more often than not, going to become permanent when liquidity is withdrawn
How does Slick.Finance Reduce the Impermanent Loss Risk to Zero:
- Slick.Finance is a Stable-Coin based yield-farming protocol with a focus on investing in Money Market Pools
- As the value of liquidity provided by investors is always pegged to 1 USD the price fluctuations or arbitrage opportunities don’t exist removing any potential impermanent loss risks
- Thus, LPs using Slick.Finance will never have a problem of impermanent loss
In addition to operating on stable-coin based pools which help reduce the (im)permanent loss, Slick.Finance plans to add multi-chain compatibility. This would offer its users the ability to work across blockchains and maximize APY — in short, seamless interoperability at the user’s fingertips.