If you are familiar with the workings of decentralized finance (DeFi), you may have heard about the term ‘Impermanent Loss’ at some point in your journey. This arises from providing liquidity to liquidity pools, which are controlled by an automatic market maker (AMM). Simply, Impermanent Loss (IL) happens when the prices of your tokens change compared to when you deposited them in the pool.
Despite the issue becoming more prevalent in the past few weeks, given the continued volatility in crypto prices, several AMMs are working to minimize the cases of Impermanent Loss. One of these projects is Bancor, a DeFi protocol offering investors high-yield staking and liquidity pooling. According to a statement by Bancor developers, the protocol is planning to soon launch “Bancor 3”, a new protocol version aiming to protect investors from Impermanent Loss, and offer more profitable returns from liquidity pools.
In this piece, we discuss Impermanent Loss (IL), the challenges that IL causes to DeFi investors, and ways the new, improved, soon-to-be-launched Bancor 3 protocol will minimize cases of Impermanent Loss.
The challenge of Impermement Loss
Impermanent Loss, as explained above, happens when you provide liquidity to a liquidity pool, and the price of the deposited tokens changes compared to when you deposited them. As the price change grows larger, the more the investor is exposed to Impermanent Loss. There’s something important you also need to understand: Impermanent Loss happens no matter which direction the price changes. The only thing Impermanent Loss cares about is the price ratio at the time of deposit.
Chart showing the relative effects of Impermanent Loss relative to the price change of the asset (Image: Medium)
The IL is usually calculated in dollar value. It is important to remember that Impermanent Loss only becomes a permanent loss when you withdraw your tokens. It has become a common issue in the DeFi space, leaving thousands of users who deposit their assets in AMM liquidity pools with negative returns. So what are the challenges that IL causes?
First, when the Impermanent Loss occurs, it can cause the cumulative value of the pooled assets to lose value, meaning it would have been better to simply HODL the tokens rather than pooling them. Secondly, Impermanent Loss can undo the value gained from the liquidity pool itself if the IL is greater than the incentives from trading fees. One study showed that roughly half of users suffer negative returns from staking in liquidity pools due to Impermanent Loss.
Offering ‘safe staking’ with Bancor V3
Bancor introduced its first AMM in 2017, ushering a new path for DeFi products and the creation of liquidity pools. The protocol offers single-sided liquidity staking that allows investors to earn higher yield with less risk. A few years later, Bancor released the ‘Bancor V2.1 to address the problem of Impermanent Loss, as the issue rose to prominence in the DeFi sector.
Bancor V2.1 introduces new features such as the ‘safe staking’ model that allows you to deposit your tokens in a liquidity pool and earn passive yield with zero risk of Impermanent Loss and single-token exposure. In the ‘safe staking’ model, users only need to deposit a single token in the Bancor liquidity pools, instead of the 50/50 asset provision model adopted by most LPs. Depositors then earn trading fees that auto-compound and are paid in the token they’ve staked.
To minimize the issue of Impermanent Loss, the protocol is designed to ensure a depositor (“LP”) gets back at least the same value as if the tokens were held in the users’ wallet plus trading fees & rewards, using a novel mechanism called Impermanent Loss Protection (IL Protection).
Once launched, Bancor V3 aims to further improve the Impermanent Loss (IL) protection mechanism, a statement reads. With the new protocol version, Bancor will make IL protection even easier and cheaper to use. This is to allow investors to earn more returns while minimizing the risk of Impermanent Loss. Additionally, the new protocol upgrade will have access to instant Impermanent Loss protection, with users no longer needing to wait 100 days for 100% IL protection.
Final words
The crypto market ranks as one of the most volatile markets today. That volatility creates trading income for users who stake their capital in AMM liquidity pools. But that same volatility creates a growing need for protection against IL. With platforms such as Bancor, users are protected from this volatility while still earning high yields from the liquidity pools.