This is the first of my educational/rant content that I am posting here via the Popsicle Finance medium. The aim really is to provide more educational content as well as lay out our thinking all around LPing. If you have any feedback join our Discord, or feel free to DM me on Twitter.
Whenever people talk about liquidity providing, the first thing a liquidity providing opponent will say is “Yeah, but you have impermanent loss”. In order to debunk and let yourself decide how to provide liquidity, I am going to explain what impermanent loss (IL) is, why it’s not permanent and how it’s somewhat different in UniV3 versus UniV2, Sushiswap etc.
If you do not know anything about how DEXs or liquidity providing work I suggest you read an article or watch a video about that first, then come back to this article.
So, what is Impermanent Loss (IL)?
First of all let’s talk about why IL happens. A market always has 2 assets. Where one asset goes up or down in comparison to the other. Thus if you are providing liquidity with 50% Asset A and 50% Asset B, if the price of Asset A goes up by 5%, your liquidity provider position will be 45% Asset A, and 55% Asset B. Why?
Well as a liquidity provider you are market making meaning you are playing both sides of the market, if someone buys Asset A, then you the liquidity provider/market maker are selling this Asset A and are buying Asset B. Thus your allocation to Asset B increases.
So at this stage IL = the change in the asset allocation of your LP pair.
When you withdraw your LP, you will withdraw the ratio of Asset A and Asset B depending on where the price is. So let’s go through an example:
You want to LP in ETH/USDT Sushiswap pool. The price of ETH is $2,000. You supply 1 ETH and $2,000 USDT in total thus supplying $4000. Now the price goes up and down and ultimately when you want your LP funds back the price of ETH is at $2,500. You now get back 0.89ETH and $2236 USDT in total, getting back $4461. You are pulling out a profit, but you could have done better by hodling the ETH and USDT as you would have had $2500+$2000= $4500. So your IL has turned into a permanent loss of 0.11ETH or $39. Of course here we are looking at IL without taking into consideration the fees you will have earned.
So, why is it not permanent?
The loss is only impermanent due to the fact that price constantly moves and as long as you are still in the liquidity pool, the price could come closer or further away from your entry price.
It becomes a permanent loss if you are pulling out of the liquidity pool.
Until you haven’t it thus is not an actual loss for you.
So strategy wise this really means that liquidity providing is more of a long term game rather than a short term game. If you are inside of a pool you are earning fees (unless you are LPing on UniV3 but we will get to that), no matter what the ratio of your asset allocation. At 0.3% of fees this is relatively substantial if you look at it from a 6–12 month perspective.
On the other hand, if you are LPing wanting to keep specific long or short exposure on a specific asset, then you will either need to find a way to hedge your LP, or LPing may not be the thing to do for your capital.
Now, how is LPing on Uniswap V3 different?
We have a whole article planned for LPing on V3, but in short, LPing on Uniswap V3 is substantially different as you are choosing the price range you want to LP at and with that also choosing the asset allocation ratio you want to start LPing at.
Imagine the price of ETH right now is at $2000, on UniV3, you could say that you only want to LP between $2100<>$3000, of course in this case you would not be earning fees at the current price and your ratio would be 100% ETH 0% USDT. On the other hand you could choose to LP between $1000<>$2000 meaning that your assets allocation ratio would be 0% ETH and100% USDT, again only earning fees if the ETH price is between $1000 and $2000.
With UniV3, you can choose how wide your liquidity provision range is, and it is this range that determines when you earn fees and what your asset allocation ratio is. The tighter your range the more fees you earn when the price is in that range. This is because of your LP being a higher percentage of the liquidity at that specific price range.
Conversely however, you increase the risk of your IL as you are tightening the range between which you are 100% in asset A or in asset B. Thus if you are not actively managing your LP you are possibly not earning any fees as you are out of the price range and ultimately experiencing 100% IL.
Due to this complication we at Popsicle.Finance decided to build Sorbetto Fragola in order to optimize Uniswap V3 liquidity providing positions. We have optimized it in order to always stay in the current price range and earn the highest amounts of fees possible, while suffering the least amount of impermanent loss.
You can check us out here: