During Dcentral Miami, Mark B. Richardson of Bancor Network led a panel to discuss Uniswap v3 impermanent losses and their effects.
DeFi Impermanent loss: “The industry’s silent killer.” Mark B. Richardson of Bancor Network was on stage at Dcentral Miami to speak and discuss impermanent loss in Uniswap v3. Impermanent loss is widespread for automated market makers (AMMs) like Uniswap. A Liquidity Provider’s position can go down in value against any of its assets.
According to Richardson, the recent release of Uniswap v3 popularized the notion of leveraged liquidity provision, which reduces the trading range in which the pool offers liquidity. Additionally, you get greater capital efficiency by reducing unnecessary collateral.
Such leverage increases the fees earned, increasing the risk assumed. In other words, the impermanent loss (IL) impacts the user’s profits as a liquidity provider. Richardson briefly explained the importance of knowing what liquidity pools are. He explained that they are a solution that arises from the need to exchange different cryptocurrencies in a decentralized and automatic way.
He also explained that financial markets need market makers to work correctly. Either based on high liquidity and order books or automated market-making based on LPs. In other words, automated market makers provide liquidity to execute operations uninterruptedly when some traded pairs are not so liquid. And in the case of liquidity pools, the users are responsible for providing this liquidity to the market.
What are Impermanent losses in Uniswap v3?
The impermanent loss would be the theoretical loss of capital between the value of an asset if you kept it in a wallet and the value of the same asset if the user wanted to withdraw it from the liquidity pool inside a DeFi platform. Simply put, this occurs when the price of one of the tokens rises or falls compared to the other. The loss is not permanent until you withdraw the assets.
Impermanent loss is known as “a silent killer in the industry” because it is difficult for users to notice. The value of a user’s holdings in a liquidity pool can increase if the composite tokens increase in price, creating the illusion of gains. However, compared to simply buying and holding the staked assets in the amounts contributed, the user may still incur losses without noticing.
Richardson commented that through his technical explanation, Uniswap launched its version 3 in March 2021, which popularized and industrialized the concept of leveraged or concentrated liquidity. “Uniswap V3 is a clever re-engineering of the leveraged liquidity concept, but it is not the seminal example. Its predecessors include the stableswap invariant introduced by Curve Finance v1 and the amplified liquidity of Bancor v2.0.”
He added that impermanent loss (“IL”) in a robust liquidity framework is complex. It must deal with the leverage introduced while accounting for out-of-range IL that does not exist in traditional AMSs. Mr. Richardson also said Uniswap v3 generates the highest commissions of any automated market maker (AMM) today. But impermanent losses could outweigh those earned commissions.
Higher profitability in HOLD
Through a graphically supported explanation, he indicated that his main conclusion is that, in general, and for almost all of the sample groups he previously analyzed in an investigation, the minimum and actual IL exceed the fees earned during the period under study.
The choice of activities harmed the average liquidity provider (“LP”) financially in the Uniswap v3 ecosystem. Furthermore, holding its assets would have been more rewarding (“HODLing“).
He noted that there are inherent risks in providing liquidity to Uniswap V3. The pools studied accounted for 43% of all Uniswap v3 liquidity at the moment of the study. The Pools analyzed generated $199 million in fees from $108.5 billion in trading volume from May 5 through September 20, 2021. Those pools suffered $260 million of impermanent losses, which amounted to $60 million in total net losses.
Importantly, this conclusion appears to be broadly applicable. Richardson collected evidence that both inexperienced retail users and sophisticated professionals experience a similar struggle to make a profit with this model. There is an exception: “flash LPs,” also known as “just-in-time” or “JIT” liquidity providers that provide liquidity for a single block to absorb commissions on upcoming trades. And then they eliminate their position instantly.
Automated market makers
In May 2021, Uniswap released its latest version of the protocol, Uniswap v3, emphasizing concentrated liquidity. In Uniswap v3, the trading area ranges into specific price brackets for each pool, and liquidity providers can choose the price range if they want their liquidity to be active.
Therefore, Uniswap v3 can achieve significantly less slippage with the same level of liquidity provided. Assuming that trading volume follows the slippage of provided liquidity and, on the reasonable assumption that trading volume follows slippage, it can also achieve a significantly higher level of commissions per unit of provided liquidity. However, these higher fees are not free, and people often ignore this: leveraging liquidity amplifies profits and risks associated with those returns.
In this case, the trade-off is to increase fee levels. Liquidity providers must also expose to higher levels of IL. The expert revealed that 49.5% of liquidity providers in Uniswap v3 had incurred damaging impermanent loss (IL) returns. He concluded by alerting all users to consider providing liquidity in Uniswap v3.