Impermanent Loss Explained
Divergence loss is another term for impermanent loss. Since the value of your pooled assets diverge as a result of market volatility.
You can either HODL (hold) your assets or deposit them in a liquidity pool (become an LP). What impact the two approaches have on your assets can be understood through this chart and the details below:
You deposit assets to a liquidity pool and over time the prices of these assets change from what you initially deposited which could be risky. If the difference in the asset prices is bigger, there is a high risk of impermanent loss.
If you have deposited in a pool containing assets in a small price range or have stable prices, you will be less exposed to the risk of impermanent loss.
However, impermanent loss is a combination of:
- Market-specific IL risk
- AMM-specific IL risk
Market-specific IL risk
It is the IL risk that arises from volatile market prices of the assets.
The LP may have a different exposure to the assets than the HODLer, even though they both started with the same asset proportion.
The LP will have the same proportion of assets only when the price reverts to the starting price. Otherwise, the LP has a different market risk.
LPs can minimize this risk by using tools that offer more control over their liquidity positions, for instance:
- Determine the mode and frequency of rebase.
- Set the % deviation from the current price and the time passed before executing a rebase.
- Distribute liquidity the way you want.
- Craft the strategies to exit with maximum yield.
- Deposit in pools with less volatile pairs. The more stable the price, the lesser the risk of loss.
- Hedge your risks by using borrowed funds to provide liquidity or buying options and power perpetuals.
- Dynamically re-hedge the position whenever the price changes.
AMM-specific IL risk
AMM-specific risk comes from AMM’s trading function.
It depends on the design of the AMM where you are providing liquidity so it can not be minimized in the same way. An AMM like Uniswap which only gives an LP a certain percentage of the assets swapped as fees has the least protection from the IL.
There are ways to minimize the AMM-specific risk like:
- Increasing the trading fees. LPs are profitable compared to HODLers when the fee generated is greater than the impermanent loss.
- Capturing the maximum extractable value and giving it to the LPs.
To deeply understand divergence loss and its types, head over to read these super comprehensive articles:
https://atise.medium.com/liquidity-provider-strategies-for-uniswap-v3-dynamic-hedging-9e6858bea8fa
https://mirror.xyz/8thousander.eth/6GaSUWDhYjXotCxLMNunJ4CbrZYPq8gRMrLE_fF2pAs
