Impermanent loss accrues when the value of a wrapped token added to an LP decreases in value versus it's unwrapped version. The loss becomes permanent when an LP provider exits their position at a lower wrapped value.
Sound confusing? It is at first, but it's not too much to unwrap. Follow along and I'll share my understanding in the clearest terms possible.
Every Investment Carries Risk
As investors, we accept the reality that inherent risks are present anywhere we decide to put our resources. We can act to prevent or minimize potential losses in many different ways.
One method is to go with stability. Though we don't stand to lose as much of our investment, that safety is reflected in smaller returns. We don't risk losing as much, but we won't profit as much either.
Liquidity Pools often set sail from the safer harbors of stability. In such cases, investors stand to earn a much higher APY than other asset allocations. They also take a higher risk of loss from their stake.
A Good Example Of Impermanent Loss
As I write, the value of LEO (unwrapped) is $0.254 USD. The value of wLEO at exactly the same time is $0.248 USD. See the discrepancy of $0.006 USD?
This is the exact definition of impermanent loss for anyone who provides liquidity to the wLEO/ETH pool on Uniswap. As it is, the value of their wLEO is less than the value of unwrapped LEO.
However, the loss is called impermanent because as long as the provider maintains their LP position (or adds to it), the values can change.
The Loss Isn't Permanent Yet
A LP provider will continue to experience impermanent loss until one of two things occur.
The value of their wrapped asset gains ground until equal or greater than the unwrapped asset. In the case of the example, the loss is clearly visible between LEO and wLEO.
The LP provider exits the pool at which point the loss becomes permanent.
The Mechanisms Behind Impermanent & Permanent Loss
To understand the mechanisms that drive impermanent & permanent loss, we must have a basic grasp of how decentralized protocols work.
It's also helpful to be aware that not every decentralized protocol follows the same algorithm. Therefore, it's key to read up on DEX protocol standards before providing assets to a pool.
Through its platform, Uniswap makes possible the creation of smart contracts. Each pool is a separate contract. Once a contract is created, providers may enter the pool.
This is done on Uniswap by matching an equal amount of the wrapped token (wLEO as an example) with an equal amount of the native token (Ethereum on Uniswap). Both assets go into the pool as one lump sum.
The Two Assets Are In Constant Fluctuation
Going back to the hypothetical example of wLEO, assume you're a LP provider. You've put in equal amounts of wLEO and ETH. Once in the pool, they change value and are no longer equal.
How does this happen? In several ways. ETH could keep a steady value while LEO (unwrapped) rises in value. ETH could plummet while LEO keeps its value.
And, of course, combinations of these events are more often the reality in a flowing market. One asset rises or falls slower than the other.
Here Comes The Arbitration
Whenever unequal values appear in a smart contract (LP) on Uniswap, arbitrars come in to close the gap. The difference in value between assets is a profit making opportunity.
If you provide liquidity to the wLEO pool, have you noticed all the swaps? Some of these may be from people using wLEO as a cross-chain asset. A good portion of those swaps is likely coming from arbitrars.
Arbitrars can pick up the wrapped asset for a lower value than the native token and profit off the difference. This mechanism of arbitrage acts to balance the matched assets of every LP provider in a pool.
What does this have to do with impermanent and permanent loss? Everything!
The mechanism of arbitrage between changing values of matched assets in a LP forces the value of the wrapped token to stray from the value of its unwrapped version.
That was a long sentence, I know. Consume each word slowly and it should make sense.
Key Takeaways For Researching Liquidity Pools
All this info about impermanent and permanent loss falls to the wayside if we don't know how to apply it to practical use.
With that in mind, here are some points that stand out from my research:
Try To Avoid Permanent Loss
- In the world of DeFi and LP's, we should expect to have impermanent loss. A poor time to exit an LP position is when the wrapped value falls below the value of the native token.
High Liquidity In A Pool Doesn't Necessarily Solve The Issue Of Loss
- What really solves the issue of loss is a rising value of both matched assets in the LP. This will drive up the value of the pool itself and offer higher returns. These rewards can far outweigh variations in value that lead to loss.
More Providers Entering The Pool
Liquidity coming into the pool shows it's gaining interest in the market. It's a benefit to the contract itself, but redistributes potential earnings among a larger group of HODLers.
An increase in providers doesn't guarantee the value of the pool will keep rising. This has as much or more to do with the value of the native token alongside the value of the wrapped token.
Research Both Pairs You Want To Add To A Pool
- Because a rising value in both the native and wrapped asset is the very best of circumstances, this is the best way to do your research.
Post wRAP Up!
When research leads you to believe in both assets, your due diligence is complete.
Final considerations may come down to an investment time frame and how much to put in the pool.
You'll want to provide at least enough to make the fees worthwhile and allow time for your reward to accrue. Be certain you can do without your assets for enough of a time period to allow your investment to pay off.
Disclaimer: This is not financial advice nor should it be construed as such.
Thanks for reading and as always...
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