The decentralized finance (DeFi) industry today has digital assets worth over $55 billion locked in various DeFi protocols, according to data from DeFi Pulse. Indeed, the rapid rise of DeFi as a viable and attractive venue to park capital and earn healthy yields has been astounding to say the least.
However, there’s a slight catch. While you can make good bucks by lending cryptocurrencies to DeFi liquidity pools (LP), there’s also a significant risk of the user incurring, what is called, an impermanent loss (IL).
What is Impermanent Loss?
Put simply, IL is the cost a liquidity provider pays in the form of their digital assets whenever the price of the assets in the liquidity pool they are invested in, changes substantially in either direction.
Let’s look at a quick example.
Joe deposits 100 DAI and 1 ETH (worth $100) in a DAI/ETH pool on Uniswap. Assuming the value of ETH increases by 10%, it will create an opportunity for arbitrage for traders who can buy ETH from Uniswap at a 10% discount and sell to external markets for a quick profit. At the same time, however, arbiters will also be required to sell an equivalent amount of DAI to balance the pool.
This way, the LPs will bear the impermanent loss for holding ETH and DAI in a liquidity pool.
This begs the question, is there a way to escape IL?
Theoretically, an LP can avoid IL if the crypto assets’ price comes back to its original price at the time of withdrawal of funds from the liquidity pool. In our example, this would mean Joe deposits 100 DAI and 1 ETH (worth $100) in a pool, and after 2 months when he withdraws it, ETH is still trading at $100.
However, as you can imagine, the chances of this happening are extremely rare in a market as volatile as the crypto market. That being said, there is still a way to escape the wrath of IL.
Enter Bancor Network
Bancor Network (BNT) is an Ethereum-based AMM that allows users to swap, stake, and earn attractive yields on their ERC-20 tokens.
Just like other AMMs such as Uniswap (UNI), SushiSwap (SUSHI), and Curve (CRV), Bancor has on-chain governance which allows vBNT token holders — the governance token of Bancor – to chart the future course of the protocol by voting on governance proposals.
However, what differentiates Bancor from its competition is its single-sided exposure in liquidity pools and IL protection.
How Does Bancor Protect from IL?
Single-sided exposure introduced by Bancor has taken the DeFi landscape by storm which reflects in Bancor’s current total value locked (TVL) which exceeds $1 billion. Single-sided liquidity ensures a user providing liquidity to a Bancor pool with a single token maintains 100% exposure to the token.
Single-sided liquidity provision allows LPs to stay long on a single token while at the same time transferring the IL risk to the Bancor protocol which aggregates and mitigates IL loss across its pools via its fees earned from its co-investments or by tapping BNT’s elastic supply.
Essentially, single-sided exposure means that users can choose to provide liquidity on only one side of any liquidity pool paired with the BNT token and stop worrying about incurring any IL. At the same time, the LPs can also collect swap fees and liquidity mining rewards assuming the latter is active on the concerned pool.
That being said, it is important to note that an LP can only ensure 100% protection from IL after providing liquidity in a pool for at least 100 days.
Refer to the following screenshot, where a user’s stake is fully protected against IL as he has successfully parked his USDT on Bancor for more than 100 days.
Any withdrawal before the 100-day maturity pool is only eligible for partial compensation.
For example, if Joe withdraws his tokens from any liquidity pool on Bancor after 50 days, he will only receive 50% compensation on any IL incurred. Similarly, for any withdrawal made before 30 days, the LP won’t be eligible for any IL protection. In essence, Bancor rewards HODLing.
In the following screenshot, we can see the user still needs to hold BNT in the respective pool for another 47 days to ensure complete protection against any IL.
Bancor’s innovative IL protection mechanism has been integrated by other DeFi protocols such as ThorChain (RUNE) into their ecosystem to safeguard liquidity providers from IL.
While IL can be mitigated through different robust mechanisms, unfortunately, it can never be truly eliminated given the technical architecture of AMMs. This, however, does not mean users should be scared of providing liquidity on AMMs.
If one wants to play it very safe, they can choose to provide liquidity in stablecoin pools such as USDT/USDC, USDT/DAI, and the like. In such pools, the cost of IL is relatively far less than in other pools due to the stable price movement of the fiat-pegged digital currencies.