Maverick 101: Impermanent Loss
Welcome to Maverick 101, a regular blog series where we explain some of the fundamental concepts of DeFi, and some of the specific features of Maverick itself!
In this installment, we’re going to look at impermanent loss (IL). Why is IL a particular pain-point in DeFi? How is this type of loss incurred? Why is it called “impermanent”? And how does Maverick offer a solution to this problem? Read on to find out!
What is impermanent loss?
Impermanent Loss refers to the loss of value experienced by a Liquidity Provider (LP) while they have money deposited in a smart contract (e.g., an Automated Market Maker).
By depositing liquidity into a smart contract, LPs essentially lock up a certain amount of their capital, meaning they can no longer freely sell it on the spot market should the price go up. IL is typically calculated by comparing the value an LP could hypothetically have received from a spot sale to the current value of their stake in the smart contract. IL is expressed as a ratio of this current value and the HODL value of the same assets, held in the same proportion as they are staked (e.g., a 50–50 split between two assets in a pair).
In other words, IL is the theoretical value lost by staking tokens instead of just HODLing them.
Why is it called “impermanent loss”?
This loss has historically been called “impermanent” because it is measured while an LP’s money is still locked in the smart contract. That is to say, IL is a dynamic metric provided to LPs so they can track their live profit and loss while LPing, and it is subject to change over time as trading occurs via the smart contract.
It has been called “impermanent” because it remains a changeable, theoretical number until such time as an LP actually removes their stake from the smart contract and actually takes a real–i.e., permanent–loss.
Because the adjective “impermanent” is confusing for some people, and because it could be taken to suggest that LPs are not experiencing real loss while their money is locked in a smart contract, some people have suggested that impermanent loss would be better described as divergent loss (based on the divergence between the value of a stake and the value in the spot market).
How does impermanent loss actually occur?
IL is an unavoidable feature of Automated Market Makers (AMMs), since these contracts are designed to trade agnostically and naively. Basically, an AMM will accept any incoming trade so long as it matches the algorithmic rules that govern pricing in its pools. This means that in situations where exterior prices have moved dramatically, an AMM will naively accept what we might think of as the “bad” side of trades.
For example, imagine a situation where BTC enjoys a pump, and the market price of 1 BTC climbs from 40,000 USD to 42,000 USD. While order book exchanges may adjust their prices to account for the pump, an AMM will not update its price without trading stimuli. The result is that an AMM-governed pool might have BTC available at 40,000 USD while the broader market values it at 42,000 USD, creating an opportunity for someone to buy it cheaply from the AMM and sell it elsewhere to capture profit from the price divergence.
The trader who comes in to buy the BTC solely on the basis of this price difference is called an arbitrageur. Arbitrageurs make profits from these price divergences, at the expense of LPs. The AMM will swap BTC (or any other asset) at prices below market value, and the pool (and thus the LPs) will receive less in return than they might have gained by swapping it themselves on a swap market. The result? Impermanent loss.
A positive way of looking at this process is that the AMM pays the arbitrageurs for price discovery. The trading activity of arbitrageurs (referred to as arbitrage) helps the AMM find an accurate price for the assets it manages. Ideally, however, an AMM would try to pay arbitrageurs as little as possible for price discovery, since the cost technically comes out of LPs’ pockets.
IL in different AMMs
In a previous 101 post, we explored different types of AMM, including the constant product AMM, variants of which are pretty much the foundational architecture of DeFi. Part of the elegance of the constant product AMM is that it presents a native protection against IL.
As we discussed in that post, the equal distribution of liquidity along the constant product curve means that traders experience a lot of slippage (i.e., the price moves in response to their trades). While slippage is not ideal for traders, it is good for LPs, since the more quickly the price moves in response to trades the less value an arbitrageur can extract from the pool.
Moreover, the particular shape of a constant product curve means that slippage increases as the price moves towards either end of the curve, making it highly unprofitable for anyone to attempt to drain the pool completely.
By comparison, the concentrated liquidity model of AMM–which was designed to reduce slippage–is actually likely to increase IL, since by making more liquidity available at a given price it actually allows arbitrageurs to swap out more of an asset before the price begins to move.
As we can see from this quick comparison, a fundamental challenge at the heart of AMM design is how to balance the interests of traders and LPs, i.e., how to limit slippage while also protecting against IL.
Why do LPs accept the risk of IL?
By depositing their tokens, LPs can be understood to be accepting a certain amount of IL in exchange for some other kind of value in return. It is therefore in LPs’ best interest to stake smart contracts that either offer the lowest IL or the best value in return (or, ideally, both!).
IL is usually offset by some kind of fee paid to LPs in return for their deposit. This is often generated by charging traders a small percentage for every trade they make with a pool. This is why good pricing is so essential to AMM-powered markets, as it will incentivize more users to trade with the pool, generating more fees for LPs.
Some protocols offer additional rewards or other incentives to LPs, often in the form of their own protocol tokens. The reason for this is that it is advantageous for protocols to have liquidity markets for their own tokens, and so it is worthwhile to incentivize people to LP with their token by paying those LPs a reward.
Again, it is an LP’s best interest to deposit their money into AMMs that can do the most to limit IL while providing the most fees/incentives to offset that IL.
How does Maverick address IL?
Maverick’s revolutionary AMM offers all the benefits of concentrated liquidity AMMs while limiting the IL exposure that–until now–has always seemed a necessary by-product of this model. Maverick’s automated liquidity placement mechanism responds intelligently to trading activity, shifting the liquidity concentration in Maverick pools quickly and efficiently. The result is that Maverick AMMs pay arbitrageurs less for price discovery than other AMM models, leaving more money on the table for LPs. All while still offering the low-slippage benefits of concentrated liquidity to traders.
On top of this, the Maverick AMM has been proven to generate more fees for LPs than a simple constant product AMM. As we have shown in our backtest results, by offering better prices to traders and aggregators, a Maverick AMM can capture more trades than competing AMMs, resulting in more fees and therefore more offset for IL.
Maverick really does promise the best of both worlds: better pricing and more fees than constant product AMMs, and lower IL than concentrated liquidity AMMs.
About Maverick Protocol
Maverick Protocol is a DeFi ecosystem that brings open, transparent, and efficient markets to everyone, powered by Maverick AMM.
Maverick AMM is an automated market maker that moves concentrated liquidity natively to achieve high capital efficiency, better prices, and effortless LPing.
Maverick AMM features an automated liquidity placement mechanism that concentrates liquidity natively and dynamically, eliminating the requirement that LPs constantly reallocate their own liquidity.
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