📝 Hi, I am 10, this is #区块链发展史 ’s popular science series, the content of this issue: Impermanent Loss!

Investment is always accompanied by risks, and the same is true for liquidity mining, so how does it come about? Is investing in liquidity mining a reliable business?

Before reading: The content of 𝟏𝟎 is step-by-step. For prerequisite knowledge, you can check historical articles. If you have any questions, you can read it by yourself! 🌤️

1. What is impermanent loss:

Impermanent loss is the difference between the value of the tokens in your LP and the value of the tokens you hold directly when you add a liquidity pool (LP). This spread is caused by the deviation between the token price in the LP and the market price. When the token price in LP is equal to the market price, the free loss is zero. The greater the deviation between the token price in LP and the market price, the greater the uncompensated loss. The income of the liquidity pool depends on the difference between the income from liquidity mining and the free loss!

2. How impermanent losses arise:

The reason for impermanent loss is that the number of tokens in LP must maintain a constant ratio, which is determined by a formula called the constant product formula. This formula ensures that the total value of tokens in LP remains unchanged, but the number and price of tokens will change with transactions. When someone uses one token to buy another token, they take one token out of the LP and deposit another token, which changes the proportion of tokens in the LP. In order to maintain the constant product formula, the price of tokens in LP will automatically adjust. In this way, the price of tokens in LP will deviate from the market price, resulting in impermanent losses.

For example, suppose you have 100 ETH and 100 BNB, and you deposit them into an ETH-BNB LP. The initial price of this LP is 1ETH = 1BNB. At this time, the total value of your tokens is 200BNB. If the price in the market changes, for example, 1ETH = 2BNB, then the proportion of tokens in LP will change. In order to maintain the constant product formula, the amount of ETH in LP will decrease, while the amount of BNB will increase. Assume that the ratio of tokens in LP changes to 50ETH and 150BNB, then the total value of tokens in LP is still 200BNB, but the value of your tokens becomes 100ETH + 75BNB = 275BNB. If you hold your tokens directly, your token value is 100ETH + 100BNB = 300BNB. In this way, you lose the value of 25BNB, which is an impermanent loss.

It also involves several mathematical formulas, so I won’t go into them one by one!

3. How to avoid or reduce impermanent losses:

-- Choose the right LP: Different LPs have different risks and benefits. Generally speaking, the more related the two tokens in the LP, the smaller the impermanent losses, such as ETH-BNB, ETH-USDC, etc. The more uncorrelated the two tokens in LP, the greater the impermanent loss, such as ETH-BTC, ETH-UNI, etc. Therefore, liquidity providers should choose appropriate LPs based on their own risk preferences and avoid those LPs with large price fluctuations.

--Use a dynamic price mechanism: Some LPs adopt a dynamic price mechanism to reduce impermanent losses, such as Curve, Balancer, etc. These LPs do not use constant product formulas, but other formulas to adjust the proportion and price of tokens in LP so that the price of tokens in LP is closer to the market price, thereby reducing impermanent losses.

--Use arbitrage to reduce the price difference between LP and the market: Arbitrage refers to the behavior of using the price difference between different markets to conduct low-risk transactions and obtain profits. When the price of tokens in LP deviates from the market price, arbitrage opportunities will arise. Arbitrage will buy low-priced tokens from LP and sell high-priced tokens in the market, or vice versa, thus Earn the difference. In this way, arbitrageurs will help the price between LP and the market converge, thereby reducing impermanent losses.

Impermanent loss is not entirely a bad thing, for example:

-- Take advantage of the LP formula feature, which is the impact of price increases or decreases on the number of tokens in LP, to go long or short on your cryptocurrency while mining.

-- Increase the stability of LP: Impermanent loss can prevent tokens in LP from being sold or purchased in large quantities, causing prices to collapse or skyrocket. This is because when the price of tokens in LP deviates from the market price, the price of tokens in LP will automatically adjust, causing traders to pay higher costs to conduct transactions, thus suppressing the intensity of transactions. In this way, LP can maintain a relatively stable price and avoid violent fluctuations.

-- Reduce price fluctuations: Impermanent losses can moderate price fluctuations in the market, making the token prices in LP smoother and more stable. This is because the price of tokens in LP is determined by a constant product formula, which can offset some price changes so that the price of tokens in LP does not fluctuate with market price fluctuations. In this way, LP can provide a more reliable and stable price reference, which is conducive to the healthy development of the market.

-- Provide a way to hedge market risks: Impermanent losses can be used as a way to hedge market risks, allowing liquidity providers to protect the value of their tokens to a certain extent. This is because when the price of one token in the market falls, the number of such tokens in the LP will increase, while the number of another token will decrease, thus offsetting part of the loss. On the contrary, when the price of a token in the market rises, the number of such tokens in LP will decrease, and the number of another token will increase, so that a part of the gains can be locked. In this way, liquidity providers can keep the value of their tokens relatively stable despite market fluctuations.

In short, impermanent loss is an inevitable phenomenon in DeFi. It has both advantages and disadvantages. When liquidity providers add LP, they should weigh the pros and cons of impermanent losses and make decisions based on their own risk preferences, return expectations, and market conditions. At the same time, attention should also be paid to the design and innovation of LP, as well as arbitrage opportunities, to reduce or avoid the impact of impermanent losses.

4. Tail:

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