Cyclical losses are one of the most well-known risks that investors must face when providing liquidity to an automated market maker (AMM) in the decentralized financial (DeFi) sector. Although this is not an actual loss incurred by the liquidity provider (LP), but rather the opportunity cost that arises compared to simply buying and holding the same assets, the ability to recover less value on withdrawal is enough to deter many investors. from DeFi.
A non-permanent loss is due to the fluctuation between two assets in a group of equal proportions – the more one asset moves up or down relative to the other, the greater the non-permanent loss. Providing liquidity to hoard coins or simply drop volatile pairs of assets is an easy way to reduce irreplaceable losses. But the returns from these strategies may not be attractive.
So the question is: Are there ways to participate in a high-yield LP pool while minimizing volatile losses as possible?
Fortunately for retail investors, the answer is yes, as new innovations continue to solve current problems in the world of DeFi, giving traders many ways to avoid irreversible losses.
Uneven liquidity pools help reduce irreplaceable losses
When talking about non-permanent losses, people often refer to the traditional compound of two assets with an equal ratio of 50%/50%, which means that investors must provide liquidity for two assets of the same value. With the development of DeFi protocols, uneven liquidity pools are emerging to help reduce diminishing losses.
As shown in the graph below, the negative value from the equality set is much greater than that from the inequality set. With the same relative change in price – for example, Ethereum (ETH) increases or decreases by 10% against the US dollar (USDC) – the lower the asymmetric relationship between the two assets, the lower the volatile loss.
Intermittent losses due to equal and unequal pools of liquidity. Source: Elaine Hu
DeFi protocols like Balancer have enabled unequal pools since early 2021. Investors can explore various unequal pools to find the best option.
Liquidity pools with multiple assets – a step forward
In addition to asymmetric liquidity pools, multi-asset liquidity pools can also help reduce losses. Once more assets are added to the pool, the diversification effects take effect. For example, with the same price action encapsulated Bitcoin (WBTC), the triple combination with a similar ratio of USDC-WBTC-USDT has less time loss than the combination with a similar ratio of USDC-WBTC, as shown below.
Liquidity pool with two and three assets. Source: Topaze.blue/Bancor
Similar to a liquidity pool that has two assets, the more assets in a pool are interconnected with several assets, the higher the permanent losses and vice versa. The 3D graphs below show the volatile losses in the triple pool of different levels of change in the price of Token 1 and Token 2 with respect to the stablecoin, provided there is only one stablecoin in the pool.
When the relative price change on Token 1 against the stablecoin (294%) is very close to the relative price change on Token 2 (291%), the permanent loss is also small (-4%).
Simulation of a periodic fall from a position. Source: Elaine Hu
When the relative price movement of Token 1 against stablecoin (483%) is completely different and far from the relative price movement of Token 2 against stablecoin (8%), the volatile loss becomes significantly greater (-50%).
Simulation of a periodic fall from a position. Source: Elaine Hu
One-way liquidity pools are the best choice
While the uneven liquidity pool and multi-asset pool help reduce permanent losses from the LP position, they do not completely eliminate them. If investors do not want to worry about irreversible losses at all, there are other DeFi protocols that allow investors to provide only one aspect of liquidity through a one-way liquidity pool.
One may wonder where to transfer the risk of irreparable loss if the investors do not bear this risk. One solution offered by Tokemak is to use the original protocol token, TOKE, to reduce this risk. Investors only need to provide liquidity such as Ether on the one hand, and TOKE holders on the other hand will need to connect to ETH to create an ETH-TOKE pool. Any non-permanent loss arising from the movement of an Ether prize against a TOKE will be covered by the TOKE holder. In return, TOKE holders charge all exchange fees from the LP pool.
Since TOKE holders are also eligible to vote on the next five pools where the liquidity will be directed, they will also be bribed by protocols that want them to vote on their liquidity pools.
