Impermanent Loss - Liquidity providers must know.

Automated market making

Incognito DEX is powered by an Automated Market-Making ( AMM ) technology.
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AMMs allow users to swap crypto assets, for example DAI for PRV, without requiring a centralized counterparty. This is unlike traditional exchanges such as Coinbase, Kraken, or Binance, which act as intermediaries between token buyers and sellers.

Whereas these companies are centralized, subject to regulations, censorship, and identity control, AMMs are simply smart-contract systems operating unstoppably on top of distributed ledgers such as Incognito & Ethereum.

One of the most important qualities of AMMs is that they require some users to act as the liquidity providers in the service. Liquidity providers commit their own asset pairs to so-called “liquidity pools”.

When using Incognito DEX and swapping PRV for DAI for example, you are trading your assets against one of these liquidity pools.

Fee structure in liquidity pools

AMMs charge a certain transaction fee to the users of the service.

These are added to the liquidity pool, and distributed to the users who committed funds to it, proportionally to their contribution.

In the case of Incognito DEX, the trading fee is 0.0%. The main reward for the liquidity providers comes from a rewards program - Supply liquidity for Incognito DEX. Provide privacy for the world.

Impermanent loss

Users who provide liquidity to AMMs can see their locked tokens change value compared to simply holding the tokens on their own.

Some users are unaware of it, others are vaguely familiar with the concept. But most people don’t really understand how and why impermanent loss occurs.

What is impermanent loss?

Impermanent loss is the main difference between holding tokens in an AMM and holding them in your wallet.

It occurs when the price of tokens inside an AMM diverge in any direction. The more divergence, the greater the impermanent loss.

Why “impermanent”?

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 + 100% of subsidized rewards.

How does It occur?

To understand how impermanent loss occurs, we first need to understand how AMM pricing works and the role arbitrageurs play.

In their raw form, AMMs are disconnected from external markets. If token prices change on external markets, an AMM doesn’t automatically adjust its prices. It requires an arbitrageur to come along and buy the underpriced asset or sell the overpriced asset until prices offered by the AMM match external markets.

During this process, the profit extracted by arbitrageurs is effectively removed from the pockets of liquidity providers, resulting in impermanent loss.

For example, consider an AMM with two assets, PRV and DAI, set at a 50/50 ratio. As shown below, a change in the price of PRV opens an opportunity for arbitrageurs to profit at the expense of liquidity providers.

  1. The DAI/PRV AMM is balanced, with equal values on both sides

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  1. The price of PRV increases by 10%, creating an arbitrage opportunity.
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  2. Arbitrageurs are incentivized to balance AMM by selling DAI for PRV, until both sides of the AMM are equal.
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  3. As a result, liquidity providers suffer a - $2.4 loss compare to holding PRV & DAI

What’s the motivation to become a liquidity provider?

By providing liquidity to the pools, providers take the risk of Impermanent loss and the reason is quite simple. The APR they earn is much higher than risks they take.

During April and May, we experimented with the Incognito DEX rewards program Supply liquidity for Incognito DEX. Provide privacy for the world. which gives up to 62.7% APR on locked PRV and up to 10% on other assets.

From June the program will be modified and simplified (details will be added here).

Further reading


Resources:

  1. https://blog.bancor.network/beginners-guide-to-getting-rekt-by-impermanent-loss-7c9510cb2f22
  2. https://tokentuesdays.substack.com/p/eliminating-impermanent-loss
  3. https://alfablok.substack.com/p/coming-soon
23 Likes

@andrey I think in 2. ETH is supposed to be PRV?

3 Likes

Fixed! Thanks.

3 Likes

Have to say I struggle with this concept. I tried with a low liquidity pair, PRV RSR, and ratio change after each trade was huge, leaving me with significant losses, in terms of percentage. I guess it makes more sense with high liquidity pairs, otherwise it’s too risky, almost like gambling.

2 Likes

So it was a bit complicated for me to understand at first. But after messing around with it, I think I have a fundamental understanding of the system.

When you provide liquidity to a pair, lets say (PRV - ETH), your basically buying into the liquidity pool. You receive shares equal to the percent ownership of the liquidity pool.

Since your providing 50% PRV and 50% ETH, the price that everything was when you bought into the liquidity pool is locked in place.
This obviously isn’t good if the price of ETH goes significantly up compared to the price of PRV. You would be losing money.

However, since your buying shares in the liquidity pool, when the price changes, and somebody else provides liquidity at a different rate, the price in the pool averages out. The more people providing liquidity, the more stable the price is.

So if you lose money, as long as more people provide liquidity and average the price back out, you should be fine. The liquidity pool is also gaining from staking PRV as well as transaction fees. This get’s rewarded to the liquidity providers based on the amount of shares owned. The longer you stay in, the more you get.

Obviously low liquidity pairs are more risky in this system, but they usually offer higher rewards to supplement that beginning gap. Non mainstream coins are gonna be harder to provide liquidity for, especially if their price fluctuates heavy.

This is personally why I believe implementing a 3rd party coin exchange into Incognito would be so beneficial. Instead of having a few really big liquidity pools, we could balance it out, to coins with lower liquidity. That would mean instead of providing liquidity for one individual coin, your providing liquidity to the whole network. I believe this approach would be better. However, I wouldn’t expect Incognito’s liquidity to be balanced between all coins, just the major ones. Maybe it could be a percentage based system, 80% of the liquidity distributed between BTC, XMR, ETH, USDC/T, DAI. Then 20% of the liquidity distributed between less traded coins.

5 Likes

Thank you, that was very clear. I will definitely avoid those low liquidity pairs.

2 Likes

Yes, I am with you and I want to see this work and I think that’s pretty close to the solution. Good stuff.

2 Likes