Permanent losses are one of the most recognized risks investors must address when providing liquidity to automated market makers (AMMs) in the decentralized finance (DeFi) sector. Opportunity costs incurred compared to simply buying and holding the same asset, rather than the actual loss incurred from a liquidity provider (LP) position, but there are many potential losses in value upon withdrawal. Enough to keep investors away. From DeFi.
Permanent losses are caused by volatility between two assets in an equal ratio pool. The more one asset moves up and down with respect to the other, the more permanent loss will be incurred. Providing liquidity to Stablecoin, or simply avoiding volatile asset pairs, is an easy way to reduce permanent losses. However, the yields from these strategies may not be very attractive.
Therefore, the problem is: Is there a way to reduce as much permanent loss as possible while joining the High Yield LP Pool?
Fortunately for private investors, the answer is yes. New innovations continue to solve existing problems in the DeFi world, providing traders with many ways to avoid permanent losses.
Non-uniform liquidity pools help reduce permanent losses
When talking about perpetual losses, people often refer to the traditional 50% / 50% equal ratio two-asset pool. That is, the investor needs to provide liquidity to the two assets at the same value. As the DeFi protocol evolves, non-uniform liquidity pools have emerged to help reduce permanent losses.
As shown in the graph below, the size of the downside of an equal ratio pool is much larger than that of a non-uniform pool. Given the same relative price changes (for example, Ethereum (ETH) increases or decreases by 10% relative to USD Coin (USDC)), the more uneven the ratio of the two assets, the less permanent loss. increase.
DeFi protocols such as Balancer have made available non-uniform liquidity pools since the beginning of 2021. Investors can explore different uneven pools to find the best option.
Multi-asset liquidity pool is a step forward
In addition to non-uniform liquidity pools, multi-asset liquidity pools also help reduce permanent losses. Simply add assets to your pool for a diversifying effect. For example, if the wrapped Bitcoin (WBTC) has the same price fluctuations, the USDC-WBTC-USDT Equal Ratio Tripool will have less permanent loss than the USDC-WBTC Equal Ratio Pool, as shown below. ..
As with the two-asset liquidity pool, the higher the correlation of assets in a multi-asset pool, the greater the permanent loss and vice versa. The 3D graph below shows the non-permanent loss in the tripool when the price fluctuation levels of token 1 and token 2 for stablecoin are different, assuming one stablecoin is in the pool. I am.
If the Relative Price Fluctuation of Token 1 to Stablecoin (294%) is very close to the Relative Price Fluctuation of Token 2 (291%), the permanent loss is also low (-4%).
If the relative price fluctuations of token 1 to stablecoin (483%) are significantly different and far from the relative price fluctuations of token 2 to stablecoin (8%), the permanent loss will be significantly higher (-). 50%).
One-sided liquidity pool is the best option
Both non-uniform liquidity pools and multi-asset pools help reduce permanent losses from LP positions, but they do not completely eliminate them. If investors don’t want to worry about permanent losses at all, there are other DeFi protocols that allow investors to offer only one side of liquidity through a one-sided liquidity pool.
If the investor does not take the risk, you may be wondering where the risk of permanent loss goes. One of Tokemak’s solutions is to use TOKE, the protocol’s native token, to absorb this risk. Investors only need to supply liquidity such as Ethereum to one side, and TOKE holders will provide TOKE on the other side to pair with Ethereum to create an ETH-TOKE pool. Permanent losses caused by Ether price fluctuations against TOKE will be absorbed by TOKE holders. In return, TOKE holders will receive all swap fees from the LP pool.
TOKE holders also have the authority to vote in the next five pools to which liquidity is directed, so they will also receive bribes from the Protocol that wants to vote in the liquidity pool. After all, TOKE holders will bear the permanent loss from the pool and will be compensated by TOKE’s swap fees and bribery fees.
Another solution is to divide the risk into different tranches to protect risk-averse investors from permanent losses and ensure that risk-seeking investors are compensated by high-yield products. Protocols such as Ondo provide senior fixed tranches with reduced non-permanent losses and variable tranches that absorb non-permanent losses but provide higher yields.
Automated LP Managers Can Reduce Investor Headaches
Even if all of the above seems too complex, investors will stick to the most common 50% / 50% equal ratio pool, actively manage LP positions using automated LP managers, and be dynamic. Can be rebalanced to. This is especially useful in Uniswap v3, where investors need to specify the range in which they want to provide centralized liquidity.
Automated LP managers implement rebalancing strategies that help investors maximize LP fees and minimize perpetual losses by charging management fees. There are two main strategies. Passive rebalancing and active rebalancing. The difference is that the active rebalancing method swaps tokens to achieve the required amount during rebalancing, while passive rebalancing does not gradually swap when the token’s preset price is reached (with limit orders). Similarly).
In a volatile market where prices are constantly leveling off, passive rebalancing strategies work well because you don’t have to rebalance frequently and pay large swap fees. However, in a trendy market where prices continue to fluctuate in one direction, active rebalancing works better because passive rebalancing strategies may miss the boat and sit outside the LP range for extended periods of time, making it impossible to collect LP fees. To do.
To choose the right automated LP manager, investors need to find a manager that fits their risk needs. Passive rebalancing strategies such as charm finance aim to obtain stable returns by using a wide LP range to reduce permanent losses. There are also passive managers such as Visor Finance who use a very narrow LP range to earn high LP fees but are exposed to more potential permanent losses. Investors need to choose an automated LP manager based not only on their risk motivation, but also on their long-term investment goals.
The profits of traditional equal ratio LPs can be compromised by perpetual losses as the underlying token moves in very different directions, but can be used by investors to reduce or completely avoid perpetual losses. There are alternative products and strategies. Investors need to find the right trade-off between risk and return to find the best LP strategy.
The views and opinions expressed here are those of the author and do not necessarily reflect the views of Cointelegraph.com. All investment and transaction movements carry risks. When making a decision, you need to do your own research.
