Impermanent Loss occurs as a result of price volatility when investors provide liquidity within an Automated Market Maker (AMM) protocol like Uniswap.
AMMs predominantly use a mathematical formula called the “constant product formula.” This formula, most simply expressed as x * y = k, states that trades must not change the product ( k- invariant) of a pair’s reserve balances ( x and y ).
What does that mean?
The product (k) of the quantities of the two assets (x and y) in the pool must remain constant. For example, if you have 10 ETH and 1000 DAI in a pool, the product is always 10,000.
Impermanent loss arises when the price of either the x or y tokens changes in price leading to an imbalance in the pool; in which case k is still 10,000 but the value are no longer proportionate. To rebalance itself, the pool has to either increase or reduce locked assets leading to impermanent Loss
To illustrate, assume a pool has a total of 10 ETH and 1,000 locked up. As a farmer yourself you lock up 1 ETH and 100 DAI which makes you eligible for 10% share of the pool. If the price of ETH rises to 400 DAI due to increased demand in the market, the ratio of ETH to DAI in the pool shifts. (now 5ETH and 2000 DAI). This is because arbitrage traders add DAI to the pool and remove ETH from it until the ratio reflects the current price. Whenever you try to pull out your liquidity, you’ll only be getting 0.5 ETH and 200 Dai (totaling $400) which in hindsight is a nice profit margin from locked initials ($200). However, if you had just held instead, you’d now have $400 worth of ETH and 100 DAI bringing your net profit to $500.
This loss is not permanent and in rare cases is reversed to an impermanent gain in the event of a decrease in ETH price. This one challenge in the AMMs’ design amongst a number of related factors makes yield farming a treacherous landscape.
Here’s a thread by bobthebuildoor that breakdown this subject and exposes the dark side of Yield Farming
However, amidst the doom and gloom of this perilous journey, a glimmer of hope endures. Thanks to the scalability of the crypto space and the ingenuity of builders, a number of protocols such as @horizondex_io and @_WOOFi, have come up with various creative solutions to neutralise the effects of impermanent loss using Concentrated liquidity, SuperChargers, and a host of others
However, some protocols have gone beyond just neutralising Impermanent loss but reversing it completely to become Impermanent Gain. Here are some that piqued my interest :
Smardex is an AMM-based Decentralised Exchange (DEX) on the Ethereum ecosystem, complete with an on-prem bridge and an innovative solution to Impermanent Loss(IL) which in some cases is transformed into Impermanent Gain (IG). SmarDex works based on formulas that manage liquidity based on Fictive Reserve as opposed to the traditional constant product formula.
In addition to the traditional AMM’s reserve of x and y tokens, Fictive Reserve introduces xf and yf which represent a percentage of the x and y reserves (50% the first time). It is now the ratio of xf and yf that determines the price of one token relative to the other
What this implies is that in a scenario where token y is in high demand leading to a price surge and thus less y token compared to x tokens in the original reserve; Smardex will unbalance the Fictive Reserve, to offer trades with more liquidity to buyers of x tokens (and sellers of y tokens ) thus incentivising more buys on x tokens thus manually balancing the pool.
On the flip side, Smardex also offers less liquidity to buyers of y tokens (and sellers of x tokens) causing price impacts in order to discourage further imbalances.
Smardex boasts of high APY farms as high as 70%, community rewards up for distribution and high-end security measures. This product basically solves yield farming biggest concerns; All except inflation
However, as we head into the bull market and Smardex expands to become multichain, a lot of potential for upside can be caught. And considering the Farming Yield Distribution Periods are deflationary, Smardex could be one of the bull winners.
SmileeFinance is an open-source, on-chain options protocol enabling volatility-based products (such as impermanent gain ) and other yield strategies.
By modeling liquidity providers as options sellers, Smilee transforms Impermanent Loss into a portfolio of options and then combines the options to create any volatility-based payoff, essentially transforming Impermanent Loss from a bug into a feature.
Volatility is a term that simply refers to the event in which the price of an asset experiences a significant move up or down
Check out this explainer video on Options
How does this play out in crypto?
Assume Chad buys a Call option (after paying the premium) that gives him the right to buy ETH at $1,700 (strike price) by the end of the month (expiration date).
- At the end of the week, If the ETH price is greater than $1,700, he wins! Chad can buy ETH at $1,700 and sell it at a higher price. (there’s a whole formula that calculates the PnL)
- However, if the ETH price is less than $1,700, it does not make sense to use his right to buy ETH at $1,700 so he simply loses the premium paid.
Notice that Chad can get enough exposure while only risking a tiny amount of liquidity paid as premium (huge leverage) does not get liquidated
Upon calculations, @SmileeFinance discovered Impermanent Loss is a concave function, which means the more the pair moves, the larger the Impermanent Loss is. This is equivalent to having a short volatility position (short gamma).
The relation between Impermanent Loss and options, allows @SmileeFinance to create a brand new primitive whereby they decompose Impermanent Loss into options and recompose them to generate any type of volatility payoff. This means that as long as there is enough liquidity on Smilee, they can mint and sell any option, on any strike, without having someone selling that option in the first place.
With this volatility primitive, SmileeFinance has created an impermanent gain option that allows you bet on market movements using insane leverage without liquidation risks.
You also get to earn real yield when you provide liquidity for Impermanent Gain options minting and trading
Although this product feeds more into the LPDfi narrative and does not directly solve the IL problem, it does, however, create an innovative stream of passive income and a new perception of IL which will serve as a foundation to future innovation in this area
Honorary mention @GammaSwapLabs
Have you learned something new with this read? consider following me at @god_crypt.