Guys, I have been playing around with Sundae Swap and Minswap, both great if you ask me and very exciting to play with DEXs for the first time.
But I have a very lose understanding of impermanent loss. My main concern is, is it in anyway predictable, or is there a worst case scenario calculation that can be made?
My understanding is that if you are locked into a contract, supplying equal liquidity to a pair of tokens, and token ‘A’ increases in value, while token ‘B’ decreases in value, then at the contract end you will be repaid the original value of the contract, but instead of receiving 50/50 of the two tokens, you may receive 60/40, or worse, with a higher percentage of the lower value (depreciating) token?
Is that correct? Any way to mitigate this risk? Any way to predict, or plan for a rapid devaluation event?
Impermanent loss happens if the price of one asset in the pool changes relative to another. You put Equal value of two assets the beginning. “Equal value” is the key word here, the token counts might be different. But if you were to convert both tokens to lets say USD, or convert one to another at current price, it would give you equal amounts.
Now, If the price in the market changes, the pool will contain more of the cheaper token and less of the more expensive token, so that their relative value will still remain equal. This property is maintained by a pool as a rule.
If you were to withdraw your liquidity at this time, you’d get more of the cheaper token, and less of the more valuable token. If you had just kept your tokens and never provided liquidity, you would have ended up better, NOT needing to lose the profit made by the more valuable token because other people naturally swapped it for the less valuable token and equalized the price with the external markets.
The best case is that the value of one asset relative to another at the time of withdrawal be the same as when you entered the pool.
It gets worse when the balance shifts in the favor of one asset, and it’s the worst possible situation if either of the assets go to ZERO.
You hope, as a liquidity provider, that the fees collected will compensate for impermanent loss, and even bring net returns. Volume in your pool is an important metric here and your rewards are proportional to it. If the volume is low, you’ll collect less fees, but still suffer the full risk of impermanent loss because people will arbitrage to equalize prices across markets nevertheless.