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Impermanent Loss in DeFi- How Liquidity Providers Can Avoid It

Financial instruments exist to help individuals and institutions save, manage, and grow their assets. Yet many investors find themselves unhappy or lacking motivation to indulge in most of the traditional asset classes due to a variety of reasons, some of which includes issues with accessibility, associated costs and regulatory red tapes, large ticket sizes combined with low returns and more. All these factors have led them on a search for attractive alternatives, conveniently offered by DeFi.

Evolving from the technology underlying Bitcoin, followed by the introduction of the first ever programmable blockchain in the form of Ethereum, DeFi is the application of the very technology to create financial solutions. DeFi, short for Decentralized Finance, now provides a viable alternative to highly centralized traditional financial systems.

DEXs in DeFi

Powered by crypto assets, the applications of DeFi range from simple exchange/swap solutions to lending, insurance, and other yield generation instruments. It is open for everyone to participate, enabling them to invest and generate returns without the hurdles faced in traditional finance. In most DeFi instruments, users are always in control of their funds and play a crucial role in ensuring continued operation of these solutions.

Decentralized Exchanges – DEXs, play a pivotal role in the DeFi ecosystem. Its importance is underlined by their presence in native form on each of the many blockchain protocols out there. Apart from allowing users to exchange one crypto asset to another, they also pave the way for various other DeFi activities like staking and yield farming.

Liquidity Provisioning on DEX

For an exchange platform to operate, they need to have liquidity in the form of tokens for each crypto pair they support. Centralized exchanges maintain a huge liquidity pool composed of user deposits along with their own funds that enables uninterrupted exchanges and trades. However, in a decentralized context, there is no centralized pool. Instead, they rely on the community members providing liquidity by depositing their holdings into respective liquidity pools, in exchange for rewards.

Such a model, automated by smart contracts is known as Automated Market Maker model and the DEXs are called AMM DEXs. Few examples of AMM DEXs on different protocols include Uniswap on Ethereum, QuickSwap on Polygon, QuipuSwap and InstaDEX on Tezos and so on.

As Liquidity Providers (LPs), community members stake their crypto assets, usually in pairs, into the liquidity pools present in automated market maker (AMM) DEXs. Other users looking to exchange their assets can select the relevant token pair listed on the platform and deposit one of tokens into the smart contract to receive an equivalent value of another into their wallets to complete the swap process.

The deposited token gets added to the liquidity pool to affect the withdrawal and transfer of the other token from the same pool.

For their contribution to the ecosystem, LPs receive a portion of the transaction fees on swaps charged by the platform from its users as rewards. Sometimes, the LP tokens received by liquidity providers as a confirmation of their contribution to the pool can be deposited in certain DeFi farms to earn additional rewards.

While liquidity provisioning acts as an attractive passive crypto income generating activity, it is also associated with risks that could lead to LPs losing large sums of value, like rug pulls, flash loan attacks and impermanent loss- the latter of which can be avoided or mitigated with the right information.

The saying “the greater the risk, the greater the reward” applies even more for a segment as volatile as cryptocurrency but a smart investor usually works around the risks present to make steady profits in the long run.

What is Impermanent Loss in DeFi?

Impermanent Loss is an unrealized loss that LPs only notice upon withdrawing their asset pairs from liquidity pools. It refers to a reduction in the dollar value of these staked assets as compared to their dollar value if the LPs just held on to them. By deciding to not withdraw their assets and wait it out instead, there’s a chance that the loss could correct itself- hence named ‘impermanent’.

How Impermanent Loss Occurs, With an Example

It would obviously make more sense to explain such a technical concept with an example that will aid in understanding better.

Let us say, a liquidity provider, LP1 decides to provide liquidity to a 50:50 ETH/DAI pool on Uniswap. The person stakes 10 ETH at a price of $1000 per token and an equivalent value of 10,000 DAI to secure a 10% stake in the pool containing a total of 100 ETH and 100,000 DAI.  Following LP1’s contribution, a user decides to swap 50,000 DAI to 50 ETH from the pool. Following the swap, the liquidity pool will have 50 ETH and 150,000 DAI.

Meanwhile, let us assume an increased demand for ETH in the market drives its value by 2x to $2000 per tokens. At this time, if LP1 were to withdraw their staked assets, which is 10% of the pool value at that moment, they will receive 5 ETH and 15,000 DAI valued in total at $25,000.

If the person had held on to the assets without contributing to the pool, it would have been worth $30,000 ($20,000 in ETH and $10,00 in DAI). By contributing and withdrawing from the liquidity pool, LP1 experienced an effective impermanent loss of $5,000.

Those who provide liquidity for highly volatile assets are at a higher risk of losing value due to the occurrence of this phenomenon. However, by keeping in mind a handful of suggestions and playing it smart they can prevent the loss of any value or at least minimize it.

Ways to Avoid Impermanent Loss

Liquidity providers can make use of multiple options provided by DeFi platforms to minimize the magnitude as well as risks of impermanent losses. Some of the tried and tested strategies include participation in yield farming, providing liquidity for stablecoin pairs or low-volatility pairs, opting for flexible pool ratios and single asset liquidity provisioning.

Yield Farming

The best form of defense is offense and LPs can be on the lookout for farming programs offered by the same protocols offering the liquidity pools. By farming the proceeds received from the pools, they can bag considerable yields that are often large enough to offset impermanent losses whose occurrence can sometimes be inevitable. A risky strategy, it is something that seasoned investors should give a try.

Stablecoin Pairs

For those wanting to play it safe, staking stablecoin pairs is the way to go. As the name suggests, the value of stablecoins remains mostly constant albeit for minor fluctuations at times. The absence of volatility with such token pairs makes the chances of dealing with impermanent loss quite low (very slight fluctuations in the value of these coins do occur sometimes).

As the least risky way to provide liquidity, one can expect to earn profits from trading fees depending on the demand for these tokens.

Low Volatility Pairs

The returns on liquidity provisioning for stablecoin pairs may be on the lower end and the next best alternative is participation in pools consisting of low-volatility crypto pairs. At a slightly elevated risk potential, users can stake their assets in such pools being assured of minor price variations between each other. They can choose to invest in those pairs that exhibit similar price fluctuations, in the same direction to evade potential losses.

Flexible Pool Ratios

For those with a greater risk appetite and keen on providing liquidity for assets that are on the more volatile side, liquidity pools that offer flexible ratios balance out the risk. Pools in popular AMM DEXs like Uniswap follow the 50:50 ratio and keep the total value of the pool constant using algorithms. However, such ratios are known to cause impermanent losses frequently.

Instead, pools where one asset has a huge weightage as compared to the other reduces and can prevent such losses. For example, certain DEXs consist of popular pools that allow users to stake token pairs at 80:20, or even 98:2 ratio. re of the ratio 80:20 or even 98:2. Any impermanent loss experienced is minimal and can be easily offset by transaction fees.

Single Sided Liquidity Pools

Pools with flexible ratios like 98:2 prevent users from facing greater exposure to the volatility of two different assets at the same time. A new breed of DEXs led by Bancor – the first protocol to deploy the AMM algorithm providing for single sided liquidity pools, followed closely by InstaDEX on Tezos ecosystem take liquidity provisioning to the next level by allowing LPs to stake and maintain complete exposure to one single asset.

Such protocols also offer protection from the impermanent loss incurred with single asset liquidity provision- a great incentive to provide liquidity to the platform. Therefore, LPs can hold their assets in the pool for long periods of time, generating passive returns in the form of trading fees, staking rewards, and compounding yields.

Investing in Single Sided Liquidity Pools

Liquidity providers can begin to invest in single sided liquidity pools by staking a volatile asset. Meanwhile, as a market maker, the protocol or other users co-invests an equivalent amount of its native tokens and charges fees on its stake until the LP withdraws their asset at which point the co-invested tokens are burnt.

The fee collected is used by the protocol to cover any impermanent loss that LPs face in these pools. Moreover, LPs can also stake these native tokens that they own on the other side of the single asset provision pools. These tokens replace those staked by the protocol which are burnt.

Single Asset Liquidity provisioning pools on InstaDEX– the first platform on the Tezos blockchain to offer Bancor like features allows users to stake any asset of their choice on the relevant liquidity pool for efficient utilisation of the user’s portfolio.

Further, the impermanent loss protection insurance offered by InstaDEX covers LPs from potential impermanent losses after a minimum staking period of 100 days. The insurance fills the difference in value of assets in case of impermanent losses during the time of withdrawal to ensure the LP doesn’t lose any value by contributing to the ecosystem.

Conclusion

Impermanent loss is a by-product of all the advantages offered by DeFi. In the existing conventional AMM structure, it may be unavoidable, but there are always options available for consideration to minimize or overcome it.

With InstaDEX, Instaraise has devised single asset staking and impermanent loss protection insurance as a way to ensure the community is encouraged for their efforts and not penalized by forcing them to accept impermanent loss under volatile market conditions.

Categories
DeFi tools

Building on Tezos: More Reasons than One Can Imagine

With blockchain ecosystems getting vibrant and versatile, more users are getting captivated by all they have to offer. However, slow speeds and expensive fees throughout the industry are causing them great inconvenience despite a slew of great applications created by developers. What is needed is a blockchain that is faster and more affordable to use.

Main Takeaways

  • Tezos is a decentralized ledger system that uses an altered Proof-of-Stake consensus mechanism called the Liquid PoS, which allows for quick throughout and increased efficiency.
  • Tezos is a future-proof protocol that can be constantly updated to meet the changing industry needs. The good part, these upgrades can happen in the background without the hassles of forking
  • Updates like Jakarta 2 and every single one before it have been crucial to its development. It has been adopted by major institutions and brands thanks to its superior performance

 

Tezos was conceptualized and created to do precisely what users want out of a blockchain- high levels of security, lightning-quick speeds and low costs. Despite facing setbacks early on, it has always been a highly utilized protocol.

Famous brands, institutions, artists and even nation-states that are understanding the importance of blockchain technology are utilizing it. It has shaped to be a great platform for developers to build their projects on.

What is Tezos?

The world’s first self-amending protocol, Tezos (XTZ) is a decentralized network built to be upgradable and offer high scalability. It is designed to limit the chances of having hard forks because of community differences.

By bringing governance on-chain, it is highly democratic by design. It is known to achieve high scalability and has successfully finalized over 1000 transactions per second thanks to its recent updates.

Tezos’s support for smart contracts has led to developers building a huge variety of decentralized applications on the network that rival the dApps ecosystem of other famous blockchains while charging users a fraction of the fees they charge.

Tezos was built keeping in mind the future of blockchain technology and is pioneering the evolution of Web3 which reflects in its mass adoption by users and developers alike. It has done so despite its past being filled with roadblocks- which it has overcome successfully.

Going Back to the Origins

A whitepaper stating the fundamentals of the Tezos network was published in 2014 by Arthur Breitman under the pseudonym L M Goodman.

The creation of the decentralized network would later begin by him and his wife Kathleen Breitman keeping in mind the tokenomics, smart contract implementation and style of governance- all of which have played a huge role in making it thrive.

In 2017 during the ICO boom, with the help of Johann Gevers- the then president of the Tezos foundation– Tezos raised over $200 million thanks to its ICO.

A power struggle between the Brietmans and Gevers would later ensue leading to the delay in the distribution of coins to investors. This caused the investors to bring a class-action lawsuit to the parties involved with the blockchain that would eventually be settled for $25 million in 2020.

Despite facing hurdles behind the scenes, Tezos has constantly been gaining a large developer base that is helping in building one of the fastest-growing decentralized networks- mainly because of how it’s designed to work.

How Does it Work?

Tezos is a decentralized ledger system that uses an altered Proof-of-Stake consensus mechanism called the Liquid PoS, which allows for quick throughput and increased efficiency.

This makes it ideal for NFTs, smart contracts, and decentralized applications. Its smart contracts are written on Michelson- a programming language made specifically for Tezos smart contracts. They essentially power the functioning of the entire ecosystem and are the logic upon which it is built.

Why Build on Tezos? A Good Question

Tezos offers plenty of reasons for the community to choose it over others. As the first-ever self-amending protocol Tezos is a future-proof protocol that can be constantly updated to meet the changing industry needs.

The good part, these upgrades can happen in the background without the hassles of forking, etc., ensuring an uninterrupted operation of projects built on the protocol. A few other things to consider while picking Tezos include:

Proof-of-Stake

Tezos’ consensus is based on the Liquid PoS mechanism. Validators referred to as ‘bakers’ are allowed to validate each block based on staking a minimum amount of XTZ- the blockchain’s native cryptocurrency pronounced as Tez that functions as its utility and governance token.

A minimum of 6,000 XTZ, called the roll amount (reduced from 8,000 XTZ after the ‘Tenderbake’ upgrade) must be staked to qualify as a baker. They are chosen to validate blocks at random.

However, the higher the stake, the greater the chances of being chosen. They are rewarded with transaction fees in XTZ as remuneration for their efforts. Moreover, users can also delegate their tokens to them in return for rewards proportional to their delegated amount.

Energy Efficient

Unlike Proof-of-Work blockchains, Tezos with its PoS mechanism is highly energy-efficient and is touted as a green blockchain. Instead of staking processing power which uses a lot of energy, bakers stake XTZ in order to finalize blocks that make it highly energy efficient.

Tezos is being looked at as the blockchain of choice for many brands and companies for various reasons- one of which is its low carbon footprint.

Institutional Grade Security

Another reason Tezos is the blockchain of choice is its high levels of security with which it wards off attackers. It is built on OCaml– an industrial-strength programming language that is relied upon by the likes of Facebook and Microsoft.

Moreover, Michelson, a low-level language that is made for developing smart contracts on Tezos offers great levels of code correction preventing bugs and errors which results in the development of highly secure contracts.

Governance by the People

Tezos is one of the few blockchains that provides high security, decentralization, and scalability together. It takes decentralization with respect to governance a step further. It brings governance onto the blockchain, unlike others that employ an off-chain governance structure.

Users who stake their XTZ are allowed to vote on changes that are proposed to the community and help in amending the network. The weight of each vote depends on the number of XTZ staked by the baker. Therefore, users can decide to stake their tokens in nodes that are voting in favor of them.

Token holders that are not bakers can also be a part of the amendment process this way. Tezos is the blockchain with the highest number of tokens staked- 76% of all XTZ in current circulation, which shows that it is truly governed by the people and is truly decentralized.

Powerful and Scalable

Due to its on-chain style of governance, the community can introduce updates for the better functioning of the network that are voted upon by stakeholders.

Over the years, based on stakeholder voting it has been able to bring about upgrades that have helped in improving its functionality. Tezos is built to scale, and its powerful architecture has been harnessed to efficiently enhance its performance leading to a flourishing ecosystem of applications.

The Ecosystem

The Tezos ecosystem houses all kinds of decentralized projects from DeFi to NFTs. It is being built by a group of developers and creators who are bringing cutting-edge innovation to the table.

Quipuswap, a decentralized exchange is one of Tezos’ biggest exchanges and provides liquidity pools that users can interact with for various purposes like borrowing, flash swaps, and yield farming- the latter of which allows users to earn huge amounts of APY on their investments.

The Wrapped Platform allows for users to wrap Tezos incompatible tokens and use them on the blockchain. The introduction of wrapped tokens has made it so much easier for tokens from other chains to interact with Tezos, bringing in a huge influx of users.

Kolibri, a stablecoin project lets users convert their tokens to stable crypto assets and use it for purposes like trading and storing assets since they have a stable value. They are also helping people that are not fans of volatility to enter the cryptocurrency world.

InstaDEX, a product of Instaraise – the first of its kind decentralized fundraising and incubator platform on the Tezos ecosystem is set to take the Tezos ecosystem by storm. As a part of the Instaraise V2.0 initiative, the team is bringing together all the DeFi components necessary to deliver end-to-end launchpad solutions for projects building on Tezos.

InstaDEX incorporates many Tezos-first features including single asset liquidity provisioning and impermanent loss insurance among others.

In addition, InstaDEX is also exploring the possibility of implementing cross-chain compatibility to enable the ecosystem projects to spread their wings beyond Tezos, driving liquidity and users to Tezos in the process. Instaraise has played a crucial role in enabling a few well-known projects to gain a foothold in the ecosystem as a part of its launchpad program.

NFTs

The Tezos ecosystem is also home to large NFT marketplaces that sell collections that are highly popular among enthusiasts.

The NFT marketplace Hic Et Nunc is the biggest of its kind on the blockchain and even beat the likes of OpenSea in trading volume for a limited period in May 2021. Tezos also houses Quincy Jones’ NFT platform- OneOf built specifically for the music industry.

With the rise of NFTs also came great concern due to environmental impacts caused by PoW blockchains. However, Tezos has helped in mining clean and green NFTs which is attracting a lot of creators to the platform. NFT collections on this blockchain possess total volumes in the millions of dollars, showing how influential its NFT ecosystem has become.

Recent Tezos Updates

Tezos has been on a roll this June. Firstly, it has partnered with Ethereum and added a cross-chain bridge that will officially allow the flow of certain tokens with increased speed between the two blockchains. Later this month it also introduced its 10th and newest upgrade- Jakarta 2. It seeks to fix the bugs that were present in its last update called Jakarta.

Thanks to community governance, Tezos has been able to grow by leaps and bounds. Updates like Jakarta 2 and every single one before it have been crucial to its development.

It has been adopted by major institutions and brands thanks to its superior performance. It was chosen by the French central bank in 2020 to power its digital currency- the Central Bank Digital Currency that will represent the bank’s Euro trails. Brands like McLaren Racing have also partnered with Tezos on multi-year deals and are releasing rare and collectible NFTs minted specifically on this blockchain.

Such trends are indicative of the fact that more institutions and brands are going to hop onto the network due to its ability to foster great development and innovation.

These reasons are more than enough for Instaraise to be on Tezos and help other projects choose the Tezos protocol over everything else.

At Instaraise, we intend to make the best use of all available features and give back by supporting more projects to realize their vision. 

To learn more about Instaraise, check us out on our website or follow us on Medium, Twitter, and Telegram