Some thoughts on the potential permanence of impermanent loss, and why @Uniswap v3 is a game-changer both for automated market maker (AMM) liquidity, and for liquidity provider (LP) risk management.
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Impermanent loss (which refers to the change in value of a liquidity provider's holdings) is one of the most misleading terms in DeFi. In practice, it is little different from mark-to-market loss.
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If you bought an asset and it sold off 20%, you wouldn't describe that as an impermanent loss. It is a mark-to-market loss, which you can choose not to realize (by remaining long the position), but which is nonetheless real.
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Whether or not you deem the loss to be permanent or impermanent is purely a function of your view on the future direction of the asset's price, and has nothing to do with how you came to be long the position in the first place.
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Going back to AMMs:
LPs are expressing a view on the tokens they provide liquidity on: specifically, a bullish and long vol view.
And LP returns can be fantastic under certain (not unreasonable) assumptions about the expected return and volatility of the underlying tokens.
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LPs are expressing a view on the tokens they provide liquidity on: specifically, a bullish and long vol view.
And LP returns can be fantastic under certain (not unreasonable) assumptions about the expected return and volatility of the underlying tokens.
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As @_Dave__White_, @MartinTassy, @_charlienoyes, and @danrobinson explain, @Uniswap LPs can do much better than long-term holders (under certain volatility assumptions), even of a token whose growth rate has positive expected value over time.
research.paradigm.xyz
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research.paradigm.xyz
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While you benefit from volatility as an LP, you are crucially still long the tokens you're providing liquidity on. In fact, you get progressively more long the worse performing of the two tokens, since you'll keep buying that token as long as it underperforms.
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In a sense, as an LP you implement quite a disciplined trading strategy: on any change in the relative pricing in the tokens you're providing liquidity on, you sell the outperformer and buy the underperformer -- and you get paid a fee to do so.
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The result is that, in a scenario in which the value of one of the tokens plummets, the LP is buying that token at increasingly attractive levels... on a relative basis, at least.
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In absolute terms, if the value of a token goes to zero, the LP is buying that token all the way down, and eventually will have fully rotated into the underperforming (and now worthless) token.
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That is a major tail risk, especially for LPs providing liquidity on tokens whose relative price is meant to be pegged at a certain level, and where meaningful drops are likely to result in a "run on the protocol" à la Titan (Source: @CoinDesk).
coindesk.com
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coindesk.com
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This is why @Uniswap v3 is such a game-changer. It allows LPs to provide liquidity over a specific price range of their choosing.
LPs can commit a smaller amount of capital to the pool, and have a stop loss of sorts, after which they will no longer be providing liquidity.
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LPs can commit a smaller amount of capital to the pool, and have a stop loss of sorts, after which they will no longer be providing liquidity.
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As @haydenzadams, @NoahZinsmeister, @sendmoodz, River Keefer, and @danrobinson put it in the @Uniswap v3 White Paper (Source: uniswap.org, highlighting from my own heavily marked up copy):
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Using the example of a token whose price is pegged at a certain level, LPs can commit less capital to provide concentrated liquidity around that price, and can cease to provide liquidity in the event of a run on the protocol (i.e., when price exits that range).
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The result is that @Uniswap v3 AMMs provide better liquidity during the normal course of trading, and LPs aren't left holding the bag in a tail scenario in which the value of one token plummets.
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That dramatically improves the risk profile of being an LP, which should encourage additional LPs to join @Uniswap v3 pools, further improving liquidity.
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