Suppose you decide to provide liquidity to a decentralized exchange (DEX) by depositing 1 Ethereum (ETH) and 1000 US dollars (USD) worth of a stablecoin like DAI into a liquidity pool. In most liquidity pools, an Automated Market Maker (AMM) algorithm is used to maintain the pool’s overall value by adjusting token prices in response to supply and demand. As tokens are exchanged in the pool, the quantity of tokens changes, leading to a concept known as “price impact,” where each purchase affects the price of the purchased token.
Pools such as sETH/ETH on Uniswap or stablecoin AMMs like DAI/USDC/USDT/sUSD on Curve contain assets that will stay relatively stable with each other. Automated Market Makers (AMMs) were first described in 2016 by Ethereum co-founder Vitalik Buterin on Reddit as a way to simplify on-chain market making on the Ethereum blockchain. A year later, Uniswap emerged and managed to establish itself as the leading Ethereum-based AMM. Finder.com is an independent comparison platform and information service that aims to provide you with the tools you need to make better decisions.
Consider One-Sided Asset Pools
DeFi platforms have also been incentivizing users to add liquidity to their pools. This is usually done by also giving rewards based on your share of the pool. On Uniswap, liquidity providers can also earn UNI tokens as an extra reward on top of the yield from providing liquidity. This can further increase profit for liquidity providers while simultaneously decreasing the impact of impermanent loss.
By tying liquidity pools with a live market price, they can automatically adjust when significant price changes occur. But if other people add assets to the pool over time and bring the total up to $2,000, you would now only be entitled to 10% of the pool. Another example is Balancer that offers pools with arbitrary weights outside of the standard 50/50 weighted model. This can also reduce the impact of impermanent loss depending on the weights in the pool.
- So if you are measuring your investment in cash, impermanent loss may not cause you to lose money.
- Then are other stable assets like sETH and stETH, which are pegged to ETH, and WBTC and renBTC, which are pegged to BTC.
- AMMs are software-controlled, autonomous decentralized exchanges where the prices of the assets held in a trading pool are controlled by an underlying algorithm.
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This provides a market for that cryptocurrency pairing that others can then use to trade. Impermanent loss happens when the price of a token changes relative to its pair, between the time you deposit it in a liquidity pool and when you withdraw it. Because as long as the relative prices of tokens in the AMM return to their original state when you entered the AMM, the loss disappears and you earn 100% of the trading fees.
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While the profitability of the concentrated liquidity model has been proven, the risk of impermanent loss (IL) remains an important topic. LPs should factor in the IL when developing a strategy for their positions. Since many LPs want to make the most out of their crypto, they are attracted to providing for smaller https://www.xcritical.in/blog/what-is-liquidity-mining/ ranges. A smaller range will result in greater liquidity concentration and higher rewards, but it also carries more risk. It represents the potential disparity in gains compared to simply holding the assets. The extent of impermanent loss exposure depends on the magnitude of price changes in the pool.
Get degen trade ideas, governance updates, token performance, can’t-miss tweets and more from Blockworks Research’s Daily Debrief. Exchange rates are set when buyers create demand and sellers offer supply. The order book matches the price a buyer is willing to pay with the price a seller is willing to accept. Impermanent loss threatens the promise of AMMs as a mechanism for democratizing liquidity provision. The only way to overcome IL is to earn more in fees than you lose through IL. This image shows how the price range changes when you select these different options.
One of the most useful tools for providing liquidity is Amberdata’s impermanent loss endpoint. With it, liquidity providers can get the exact data needed to evaluate IL risk for token pairs in specific liquidity pools on different DEXs. Uniswap charges 0.3% on every trade that directly goes to liquidity providers. If there’s a lot of trading volume happening in a given pool, it can be profitable to provide liquidity even if the pool is heavily exposed to impermanent loss. This, however, depends on the protocol, the specific pool, the deposited assets, and even wider market conditions. Liquidity providers depositing token pairs into the liquidity pool stand to earn the transaction fee for every swap that occurs in the pool.
Impermanent loss occurs due to the rebalancing movements within a liquidity pool, presenting a risk for liquidity providers who stake their assets in the pool. Uniswap takes a 0.03% fee from every trade and gives it to the liquidity providers. The higher the volume of trades is, the more revenue is generated for the liquidity providers. Below you can see that the fees generated over 24 hours for the ETH/USDC pool is over $402,000. The higher your share of this pool is, the more revenue you receive from that $402,000. Therefore, liquidity providers are incentivized to participate in AMMs because they earn fees and yield in the form of newly-issued protocol tokens.
Staking is the process of actively participating in transaction validation by adding token/coin to the liquidity pool. More often than not, impermanent loss becomes permanent, eating into your trade income or leaving you with negative returns. It occurs when the price of tokens inside an AMM diverge in any direction. The earnings from your LPs are represented by the received fees (see value under “Unclaimed Fees”). Again, the fees are not fixed and you receive fees only when someone uses the pool for swapping.
Balancer allows LPs to create custom ratios for assets within a pool, allowing users to bet on the asset they believe will outperform. That way, LPs can then mitigate their losses if the market moves the way they believed it would. For liquidity providers in AMM protocols, one of the primary risks to be aware of is Impermanent Loss (IL). So far, we have used the straightforward formula (4) to calculate impermanent loss. While it is great for measuring your current IL, it’s not convenient if you are looking to plot different IL values for different price changes. By prefunding a pool like this, AMMs avoid the need to pair buyers with sellers.
If Bob withdrew his funds, he would have made some money thanks to the liquidity rewards. But what if he just held on to his 1 ETH and 5,000 EBOB instead of liquidity mining? It would have grown to $15,000, a 50% profit in a month, which is very unlikely to happen with liquidity mining rewards.
Writing for cryptocurrency exchanges, he has documented some of the key blockchain technological advancements. Due to rebalancing, the number of tokens on either side of the pool has changed, even though https://www.xcritical.in/ the values have remained the same. Y is the amount of the other and k is the total liquidity in the pool. When the total liquidity, k, changes, the ratio of x and y must adjust to remain balanced.