Impermanent Risk (IR) is one of the least understood topics within the DeFi space. Retail traders with little experience managing LP’s can often get caught out due to their misunderstanding of how IR impacts their portfolio.
We have written a little material on what IR is and how it functions (https://docs.vyfi.io/vy-finance-products/dex/risks-and-impermanence), but we would like to take this opportunity to discuss IR in direct relation to a traders portfolio and net portfolio risk.
Lets run through an example of holding two tokens, A and B, and compare this to just holding all your value in Token A outright. The numbers below have been simplified for ease of the reader, and do not include Token B changing price, arbitrage on Token A or B, fees, or slippage. Or as they would say in an Economics class — all things being equal.
I have $500 in token A, and $500 in token B, with a net value of $1000. These are currently represented by 5 A Tokens, and 5 B Tokens. Each token, A and B must be worth $100 each in this case.
Scenario 1: Token A drops by 50%
For this to hold true within the liquidity pool, the ratio of the pool must shift, so that the value of token A is half that of token B. Ie. the ratio of the LP’s move from 1:1 -> 1.5:1
Given their initial prices, the ratio was 1:1, and now its 1.5:1 (as price has halved on token A), the net value in token A is = 7.5 (amount token A) + 3.3333 × (1.5/0.6666) (amount token B values in token A) = 7.5+7.5 = 15 TOKEN A. Remember, value on both sides is always equal. As we are working with a liquidity pool in isolation — the price of Token B must go up when the price of token A goes down as the values are relative to each other.
Each side is now worth 7.5 Token A, or $325. Since we have two sides to the liquidity pool, the total value will be $750, whereas without the liquidity pool, the total value on Token A held outright would be $500. This is called Impermanent Gain (IG) — when the loss of value on a token results in a net positive reduction in portfolio value due to your LP. In the above example, the IG on the position is +$250.
This is also true in reverse, where if Token A doubles in price, the LP will experience a similar shift in the opposite direction. This would result in a net portfolio value of $1,250 if you hold the LP’s, or a net portfolio value of $1,500 if you held Token A outright. This is the circumstance that results in IR, in this example, the IR on the position is -$250 (16.6%). This IR change can be summarized in the following grid:
Price Difference between token A and B results in the following IR/IG, depending on the direction of the price move (Token A, or Token B moving faster). IG can be thought of as the “hedging power” of the LP against holding the net value of the Token outright.
125% — 0.6% IR/IG
150% — 2% IR/IG
200% — 5.7% IR/IG
300% — 13.4% IR/IG (This corresponds to the above example)
500% — 25.5% IR/IG
Reference: https://pintail.medium.com/uniswap-a-good-deal-for-liquidity-providers-104c0b6816f2
Highly recommended for a more mathematical description of the impact of IR on Net Token Amount held in LP. This article does not describe Value Change on the net LP’s dollar cost.
If users want to play around with an example liquidity pool, and see how trades effect the tokens contained — we have included one here: Liquidity Pool. To set up the above scenario, just put a ratio of 1:1 between Token A, and Token B, and you can play around with how different trade sizes will impact the liquidity pool.
Below is an example of the flows within an LP depending on the direction that the price is moving on the tokens contained. This is given using VYFI and ADA as an example:
How does IR/IG hedge my net portfolio position?
If you held $1000 of just Token A, and it halves — well, the total value is now $500. Ie. By engaging with impermanent risk on the net portfolio of $1,000 — you save $250 in loss vs just holding token A outright. This also assumes Token B doesn’t change in price, and there are no arbitrage pools to balance the subsequent price action on Token B. In reality, the values for this will change depending on multiple factors — including the depth of both markets, the total fees being earned on the pool, the total number of arbitrage markets, etc. These numbers are difficult to calculate perfectly in true market conditions.
Using the image above as a guide, if ADA goes UP with respect to VYFI, or if VYFI goes down with respect to ADA — we are experiencing IG. Why?
Lets assume we are holding 1000ADA in VYFI outright. If ADA goes up and VYFI stays the same, I am losing value I would have gained if I held the ADA instead. By engaging with the liquidity pool, I am now being paid VYFI whilst ADA is raising in Value — ie. The liquidity pools LP is gaining Value, whereas holding VYFI outright would not gain value. This difference in value gain is the IG.
Similarly, if VYFI is going down, we are earning more VYFI being paid into the pool, and the IG is reducing LP’s at approximately half the rate of holding VYFI outright. The difference between these values would be your IG.
Impermanent risk is one of the least understood concepts in trading on DeFi. It is an incredibly useful structure to assist in hedging your positions when you hold multiple crypto-currencies outright. VyFi also offers a tool called Layer-2 Liquidity Pools. These liquidity pools are made up of 75% ADA, and 25% Token. This is similar to a balancer 80/20 pool.
To read more about how these structures can reduce your IR, check out this article here:
https://vyfinance.medium.com/farming-on-layer-2-liquidity-pools-how-does-it-work-bd52808ecdfa
