Crypto conspiracy theories abound, but prop traders are just doing their job

June 26, 2022 Coin Telegraph

Alameda

FTX founder Sam Bankman-Fried and Alameda Ventures made recent headlines for bailing out a handful of CeFi crypto platforms this week, but what exactly do market makers do?

Alameda Research is a cryptocurrency trading firm and liquidity provider founded by crypto billionaire Sam Bankman-Fried (SBF). Before founding his firm in 2017, SBF spent three years as a trader at the quantitative proprietary trading giant Jane Street Capital, which specializes in equity and bonds.

In 2019, SBF founded the crypto derivatives and exchange FTX, which has quickly grown to become the fifth-largest by open interest. The Bahamas-based exchange raised $400 million in January 2022 and was valued at $32 billion.

FTX’s global derivatives exchange business is separate from FTX US, another entity controlled by SBF, which raised another $400 million from investors including the Ontario Teachers Pension and SoftBank.

The self-made billionaire has big dreams, like purchasing finance giants like Goldman Sachs, and in July 2021, he previously mentioned that “M&A [mergers and acquisitions] is going to be the most likely use of the funds,” raised from investors.

On June 18, crypto brokerage Voyager Digital announced that Alameda Research had agreed to give the company a 200 million USD Coin (USDC) loan and a “revolving line of credit” of 15,000 Bitcoin (BTC) worth $319.5 million at current prices.

During an interview with NPR on June 19, SBF stated that Alameda Research and FTX “have a responsibility to seriously consider stepping in, even if it is at a loss to ourselves, to stem contagion.”

In the interview, SBF noted that his companies had done this “a number of times in the past,” including a $120 million loan to the then financially-troubled Japanese crypto exchange Liquid.

This news raises some interesting questions, but more importantly, traders should understand what a proprietary trading firm is and how market makers work in the crypto industry.

What is a proprietary trading firm?

Proprietary trading means the investment firm or vehicle uses their own money instead of seeking commissions from clients’ trading. Banks and financial institutions use this trading strategy to make profits, carving risk from their balance sheet.

By applying sophisticated modeling and trading software, quantitative firms resort to diverse strategies to find a competitive advantage over regular traders and investors, including arbitrage, derivatives and high-frequency market access.

Also known as “prop trading,” this activity is a popular concept in traditional finance, bonds, stocks, commodities and debt instruments.

What’s liquidity provision?

Entities that provide liquidity facilitate trading in financial instruments by offering their own resources so that buyers and sellers can easily trade. Liquidity is the ability to convert an asset into cash, so, essentially, “liquidity providing” means market-making.

Market makers are regulated entities in traditional finance. Their job is to keep a minimum bid and ask for quotes at all times so that investors find the necessary liquidity when entering or exiting a market.

This process is usually handled by specialized trading firms, but the activity can also be carried out independently. Official market markets have access to lower trading fees and funding, but anyone can run arbitrage trades at their own expense and risk.

What is Alameda Research’s involvement with crypto?

Alameda Research, Jump Trading and DRW Cumberland, are some of the leading prop trading firms that provide liquidity for centralized exchanges and decentralized finance (DeFi) usage.

These businesses aim to generate profit for their respective shareholders, but sometimes this means creating direct exposure to crypto assets and intermediaries. In a nutshell, they take on risk for a potential longer-term gain — risk is a key part of the liquidity-providing business.

The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph. Every investment and trading move involves risk. You should conduct your own research when making a decision.

Voyager Digital cuts withdrawal amount as 3AC contagion ripples through DeFi and CeFi

June 23, 2022 Coin Telegraph

3AC

Traders brace for more bad news after headlines revealed that Voyager Digital had lent $655 million to Three Arrows Capital. Is another crypto market sell-off on the way?

The Singapore-based crypto venture firm Three Arrows Capital (3AC) failed to meet its financial obligations on June 15 and this caused severe impairments among centralized lending providers like Babel Finance and staking providers like Celsius.

On June 22, Voyager Digital, a New York-based digital assets lending and yield company listed on the Toronto Stock exchange, saw its shares drop nearly 60% after revealing a $655 million exposure to Three Arrows Capital.

Voyager offers crypto trading and staking and had about $5.8 billion of assets on its platform in March, according to Bloomberg. Voyager's website mentions that the firm offers a Mastercard debit card with cashback and allegedly pays up to 12% annualized rewards on crypto deposits with no lockups.

More recently, on June 23, Voyager Digital lowered its daily withdrawal limit to $10,000, as reported by Reuters.

The contagion risk spread to derivatives contracts

It remains unknown how Voyager shouldered so much liability to a single counterparty, but the firm is willing to pursue legal action to recover its funds from 3AC. To remain solvent, Voyager borrowed 15,000 Bitcoin (BTC) from Alameda Research, the crypto trading firm spearheaded by Sam Bankman-Fried.

Voyager has also secured a $200 million cash loan and another 350 million USDC Coin (USDC) revolver credit to safeguard customer redemption requests. Compass Point Research & Trading LLC analysts noted that the event "raises survivability questions" for Voyager, hence, crypto investors question whether further market participants could face a similar outcome.

- Unsecured derivatives and options trading on Deribit
- $650 million of unsecured debt with Voyager
- Offering protocols/portfolio companies 8-10% APY on their cash balances

What else?
— Dylan LeClair (@DylanLeClair_) June 22, 2022

Even though there is no way to know how centralized crypto lending and yield firms operate, it is important to understand that a single derivatives contract counterparty cannot create contagion risk.

A crypto derivatives exchange could be insolvent, and users would only notice it when trying to withdraw. That risk is not exclusive to cryptocurrency markets, but is exponentially increased by the lack of regulation and weak reporting practices.

How do crypto futures contracts work?

The typical futures contract offered by the Chicago Mercantile Exchange (CME) and most crypto derivatives exchanges, including FTX, OKX and Deribit, allow a trader to leverage its position by depositing margin. This means trading a larger position versus the original deposit, but there's a catch.

Instead of trading Bitcoin or Ether (ETH), these exchanges offer derivatives contracts, which tend to track the underlying asset price but are far from being the same asset. So, for instance, there is no way to withdraw your futures contracts, let alone transfer those between different exchanges.

Moreover, there's a risk of this derivatives contract depegging from the actual cryptocurrency price at regular spot exchanges like Coinbase, Bitstamp or Kraken. In short, derivatives are a financial bet between two entities, so if a buyer lacks margin (deposits) to cover it, the seller will not take the profits home.

How do exchanges handle derivatives risk?

There are two ways an exchange can handle the risk of insufficient margin. A "clawback" means taking the profits away from the winning side to cover the losses. That was the standard until BitMEX introduced the insurance fund, which chips away from every forced liquidation to handle those unexpected events.

However, one must note that the exchange acts as an intermediary because every futures market trade needs a buyer and seller of the same size and price. Regardless of being a monthly contract, or a perpetual future (inverse swap), both buyer and seller are required to deposit a margin.

Crypto investors are now asking themselves whether or not a crypto exchange could become insolvent, and the answer is yes.

If an exchange incorrectly handles the forced liquidations, it might impact every trader and business involved. A similar risk exists for spot exchanges when the actual cryptocurrencies in their wallets are shorter than the number of coins reported to their clients.

Cointelegraph has no knowledge of anything abnormal regarding Deribit's liquidity or solvency. Deribit, along with other crypto derivatives exchanges, is a centralized entity. Thus, the information available to the general public is less than ideal.

History shows that the centralized crypto industry lacks reporting and auditing practices. This practice is potentially harmful to every individual and business involved, but as far as futures contracts go, contagion risk is limited to the participants' exposure to each derivatives exchange.

Wire Network’s new protocol aims to end Web3 interoperability woes

June 23, 2022 Coin Telegraph

Coin Telegraph

The protocol promises to eliminate complexities seen with existing interoperability solutions and requires no bridges or oracles to integrate.

Layer-1 blockchain platform Wire Network announced the launch of its blockchain interoperability protocol called Universal Polymorphic Address Protocol (UPAP).

In the Web3 ecosystem, which is comparatively nascent to the larger crypto market, the primary interaction occurs over digital goods and NFTs. However, the growing number of Web3 platforms lack interoperability which could be a huge roadblock to a seamless Web3 experience. Wire Network aims to change that with its universal wallet address protocol.

Blockchain interoperability is the ability to share information across different blockchain networks without restrictions. With the evolution of the blockchain industry, hundreds of new protocols and blockchain standards have emerged. Thus, the interactions among different blockchains become complex. This is where interoperability helps in bridging that gap.

The new UPAP protocol aims to address the interoperability problem in the web3 ecosystem. While there have been several interoperability solutions in the past, most of them were limited to a particular ecosystem or a particular issue such as liquidation and fund transfers.

Interoperability can be achieved via different methods such as cross-chains, sidechains, proxy tokens, swaps, etc. Many blockchain platforms have focused on interoperability in the past, for example, Polkadot allows different blockchains to plug into a larger, standardized ecosystem while Cosmos employs an inter-blockchain communication (IBC) protocol to establish blockchain interoperability.

UPAP, on the other hand, promises to offer an interoperability solution with universal readable wallet addresses to send and receive nonfungible tokens (NFTs), perform cryptocurrency swaps, and add liquidity pairs across any blockchain.

The interoperability solution gets rid of most of the complexities involved with existing solutions and requires no bridges or oracles.

Anyone can integrate the UPAP wallet into a blockchain that uses Elliptic Curve Digital Signature Algorithm (ECDSA) cryptographic algorithm. Users will need to import the mnemonic code from their choice of wallet and UPAP would create a universal address, using which users can send any asset across any blockchain.

This is what’s standing in the way of DeFi’s ‘NFTification’

June 22, 2022 Coin Telegraph

Blockchain

NFTs and DeFi have taken the world by storm in recent years, but both industries have downsides. Bringing them together could be a force for good.

Ask someone what an NFT is, and they'll instinctively think of digital art — the CryptoPunks, Bored Apes and Ether Rocks that have sold for eye-watering sums.

In some circles, nonfungible tokens have been dismissed as a vehicle for speculation, with critics lamenting that demand for such assets is fueled by greed.

But this argument doesn't give us the full picture. We're barely scratching the surface of what these one-of-a-kind tokens can achieve — and new use cases are continually emerging.

The music industry is tentatively exploring what NFTs have to offer. Live Nation, one of the world's biggest entertainment companies, has started offering digital versions of ticket stubs — giving fans a virtual memento of the gigs they've attended. Other platforms are allowing consumers to invest in new music and receive a share of the royalties. TV shows and films are being funded through NFTs too — and despite a backlash from players, gaming brands are also dabbling in this technology.

NFTs also have the potential to improve existing crypto services, with DeFi being one of them. What if this technology could be used to unlock access to specific permissioned services… and could we see popular crypto collectibles be widely used as collateral?

While the "NFTification" of the decentralized sector is seen as inevitable in some crypto circles, there are some hurdles that need to be overcome. Let's explain why.

NFTs cost a mint

Inevitably, any discussion of what's holding NFTs from playing a bigger role in the DeFi ecosystem needs to begin with the cost of minting such tokens.

Even on a robust Layer 2 network, transaction fees mean it's often uneconomical to create, distribute and trade NFTs. This particularly explains why these crypto collectibles are so exorbitantly priced — not to mention why new use cases for nonfungible tokens are only being explored at a glacial pace.

As traders impatiently wait for Ethereum's Proof-of-Stake network to launch, this blockchain has become unaffordable for many everyday users. While faster, cheaper and more scalable rivals have emerged in recent years, some have been blighted by repeated outages — bringing their reliability into question.

But what if users could be offered a completely gas-free experience while transacting? Could this be the silver bullet that attracts tens or hundreds of millions of users to the space — people who would be drawn in by the development this would encourage?

Such an approach would be beneficial for NFTs and the DeFi sector alike, giving crypto enthusiasts the freedom to transact how they wish without worrying about the cost. But from an infrastructure perspective, there are other issues that need to be taken into account.

Innovating in DeFi

Right now, high gas fees mean trading and farming is financially impractical for smaller users — while slow bridges that connect the Ethereum mainnet to Layer 2s cause frustration. A lack of stickiness has also emerged in the DeFi space — with users frequently moving from platform to platform in search of the best short-term opportunities.

Of course, an even bigger barrier involves getting people to see what decentralized protocols and automated market makers (AMMs) have to offer. A poor user experience — and more sophisticated features on centralized platforms — often give investors little incentive to make the jump into DeFi. The downside here is consumers end up relinquishing control over their own crypto as a result.

But it doesn't have to be this way — and one team says it has built the first NFT-powered AMM that has been designed "from the ground up to solve a series of critical problems for DeFi."

A gem of a product

Ruby.Exchange is building its infrastructure on SKALE, which is described as a powerful, multi-chain solution for Ethereum. SKALE's chains have zero gas costs — and boast a fast, decentralized and secure bridge to the mainnet where transfers in either direction can take minutes, rather than hours or even days.

And while the value of NFTs can be uncertain, with limited ways they can be used, Ruby offers gemstones — "beautiful, generative artworks that drive loyalty by embodying real utility as well as artistic value." These assets have a starring role within its AMM.

This exchange says it delivers a feature rich and gamified user experience where NFTs are minted for user profiles, as vouchers for trading fee rebates, and to ensure customers can access the premium features they've come to expect — native charting and advanced analytics among them. Yield farming boosts are another use case.

What's more, a gamified trading and farming experience delivers that elusive "stickiness" that DeFi protocols currently lack — rewarding long-term engagement and benefitting all users by helping prevent capital from migrating elsewhere, which affects liquidity.

Looking ahead, new classes of NFT gemstones are going to be created — and as Ruby's analytics and liquidity provider management dashboard is established, ownership of nonfungible tokens will be key to unlocking access.

NFTs and DeFi have shown so much promise in their early days, transforming the worlds of art and finance. Ruby.Exchange is now determined to show how powerful the "NFTification" of decentralized finance can be.

Learn more about Ruby.Exchange

Disclaimer. Cointelegraph does not endorse any content or product on this page. While we aim at providing you with all important information that we could obtain, readers should do their own research before taking any actions related to the company and carry full responsibility for their decisions, nor can this article be considered as investment advice.

Babel Finance Halts Withdrawals, Citing Low Liquidity

June 17, 2022 The Crypto Briefing

Do Kwon dismisses allegation of cashing out $2.7B from Terra (LUNA), UST

June 12, 2022 Coin Telegraph

Do Kwon dismisses allegation of cashing out .7B from Terra (LUNA), UST

bitcoin cash

The rumor surfaced after a Twitter thread by @FatManTerra shared the alleged details on how Kwon, along with Terra influencers, managed to drain funds while artificially maintaining the liquidity.

Do Kwon, the CEO and co-founder of the infamous Terra (LUNA) and TerraUSD (UST) ecosystems, refuted the claims of cashing out $80 million every month for nearly three years.

Numerous unconfirmed reports surfaced on June 11, claiming Kwon’s participation in draining liquidity out of LUNA and UST before the crash to purchase US dollar-pegged stablecoin such as Tether (USDT).

Rumors about Kwon cashing out LUNA and UST reserves surfaced after a Twitter thread by @FatManTerra shared the alleged details on how Kwon, along with Terra influencers, managed to drain funds while artificially maintaining the liquidity.

Some of you thought $80m per month was bad. That's nothing. Here's how Do Kwon cashed out $2.7 billion (33 x $80m!) over the span of mere months thanks to Degenbox: the perfect mechanism to drain liquidity out of the LUNA & UST system and into hard money like USDT. (1/13)
— FatMan (@FatManTerra) June 11, 2022

However, the entrepreneur advised the crypto community to steer away from fueling the rumor until it was proven true:

“This should be obvious, but the claim that I cashed out $2.7B from anything is categorically false.”

Sharing his side of the story, Kwon stated that the recent rumor of cashing out $80 million per month contradicts the claims that he still holds most of his LUNA holdings, procured during the airdrop. Moreover, Kwon further reiterated that his income over the past two years has only been a cash salary from TerraForm Labs (TFL).

3/ To reiterate, for the last two years the only thing ive earned is a nominal cash salary from TFL, and deferred taking most of my founder’s tokens because a) didn’t need it and b) didn’t want to cause unnecessary finger pointing of “he has too much”
— Do Kwon (@stablekwon) June 12, 2022

Kwon told the community that “spreading falsehood” adds to the pain of all LUNA investors, remarking that:

“I didn’t say much because I don’t want to seem like playing victim, but I lost most of what I had in the crash too. I’ve said this multiple times but I really don’t care about money much.”

Mr. B, a developer from Anchor Protocol, a Terra-centric sub-ecosystem, allegedly warned Kwon about the unrealistic high-interest rates. Mr. B said that the platform was designed only to offer an interest rate of 3.6% for keeping the Terra ecosystem stable, but was changed to 20% just before the release:

“I thought it was going to collapse from the beginning (I designed it), but it collapsed 100%.”

The developer allegedly suggested to Kwon about lowering the interest rates but the request was refused. Do Kwon has been summoned to attend a parliamentary hearing on the matter in South Korea in mid-May.

Lido Deploys Additional Curve Pool to Improve Liquidity Around Bonded ETH Peg

May 13, 2022 Bitcoin.com

Bancor 3 goes live with impermanent loss protection for liquidity providers

May 11, 2022 Coin Telegraph

Bancor

Bancor’s new liquidity mining strategy promises to bring organic on-chain liquidity and make DeFi staking easier for DAOs.

Bancor, the first decentralized finance protocol to introduce liquidity pools, has come out with a new liquidity solution with the launch of its v3, called Bancor 3.

Bancor 3 went live with a promise to offer protection against impermanent loss to liquidity providers. The new architectural changes promise to bring sustainable on-chain liquidity and make decentralized finance (DeFi) staking simpler for decentralized autonomous organizations (DAOs).

The v3 project has attracted more than 30 projects and tokens — including Polygon’s MATIC, Synthetix Network Token (SNX), Yearn.finance’s YFI, Brave’s Basic Attention Token (BAT), Flexa’s AMP and Enjin Coin (ENJ) — and several DAOs for its new protocol launch.

The single-sided staking was first introduced with Bancor v2 to protect traders against impermanent losses; however, the last version suffered from a high barrier of entry and high gas fees. With v3, Bancor promises full impermanent loss protection and minimal gas fees.

Liquidity is the backbone of the DeFi ecosystem, but many leading protocols have faced a severe crisis in maintaining a long-term liquidity mining strategy. Talking about the key architecture changes and the new liquidity solution, Mark Richardson, product architect at Bancor, told Cointelegraph:

“In Bancor 3, the protocol utilizes an improved set of operations that allows the network to better manage its liabilities, resulting in a more cost-efficient method of providing impermanent loss compensation.”

Bancor 3 introduces several new architectural changes and features, including Omnipool, instant impermanent loss protection, auto-compounding rewards, dual rewards and superfluid liquidity. Omnipool is a single virtual vault for token liquidity. Richardson explained that Omnipool can use protocol-earned fees from one pool to compensate a user’s impermanent loss in another pool. This should cut down the transaction fee slippage and ensure efficiency.

The auto-compound earning mechanism ensures that trading fees and rewards are auto-compounded with zero transaction fees simultaneously used as liquidity inside the pool from day one. This mechanism ensures dual-earning for third-party projects.

Anchor Protocol rebounds sharply after falling 70% in just two months — what’s next for ANC?

May 7, 2022 Coin Telegraph

Altcoin

The total value locked inside the Anchor Protocol's liquidity pools reached an all-time high earlier this week.

Anchor Protocol (ANC) returned to its bullish form this May after plunging by over 70% in the previous two months.

Pullback risks ahead

ANC's price rebounded by a little over 42.50% between May 1 and May 6, reaching $2.26, its highest level in three weeks. Nonetheless, the token experienced a selloff on May 6 and May 7 after ramming into what appears to be a resistance confluence.

That consists of a 50-day exponential moving average (50-day EMA; the red wave) and 0.786 Fib line of the Fibonacci retracement graph, drawn from the $1.32-swing low to the $5.82-swing high, as shown in the chart below.

*ANC/USD daily price chart. Source: TradingView*

A continued pullback move could see ANC's price plunging towards its rising trendline support, coinciding with the floor near $1.67 that preceded a 175% price rally between Feb. 20 and March 5.

Meanwhile, a decisive break below the trendline would risk crashing ANC towards the 1.00 Fib line near $1.32, almost 30% below today's price of $1.92.

Conversely, ANC's daily relative strength index (RSI) readings rose from below 30 (oversold) to around 50 in the last seven days, hinting at upside strengths in the Anchor market unless the readings cross 70, the overbought threshold.

As a result of favorable RSI, the Anchor Protocol token has the potential to break above the resistance confluence around $2.28, with its next upside target lurking around the 0.618 Fib line near $3.

Anchor Protocol TVL hits record high

The sharp upside retracement in the Anchor Protocol market also coincides with a continued capital inflow into its liquidity pools.

In detail, the total value locked (TVL) inside the Anchor's savings and borrowing pools surged to $16.48 billion on May 7 from $8.6 billion at the beginning of this year — almost a 100% rise. In doing so, Anchor reserves also reached a record high of $17.15 billion on May 5, data from DeFi Llama shows.

*Anchor Protocol TVL. Source: DeFi Llama*

Users continued to commit funds to Anchor Protocol primarily due to its steeper annual yield of 19.5%. That has made it the largest liquidity pool within the Terra (LUNA) blockchain ecosystem.

Anchor has also expanded its services to Avalanche (AVAX), another base-layer blockchain, and now plans to function atop the Polkadot (DOT) ledger.

ANC is a governance token within the Anchor Protocol's "decentralized money market" ecosystem. It also offers holders a percentage of protocol earnings. Thus, Anchor Portocol's expansion into other blockchain ecosystems promises to generate more demand for ANC.

Additionally, proposals like vote-escrowed ANC, which enables holders to lock their tokens for a preset period in return for better voting rights and staking rewards, could also drive up ANC's demand.

The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph.com. Every investment and trading move involves risk, you should conduct your own research when making a decision.

What is impermanent loss and how to avoid it?

April 25, 2022 Coin Telegraph

Coin Telegraph

Read this guide to understand the risk, known as impermanent loss (IL), that liquidity providers take in exchange for fees earned in liquidity pools.

How to avoid impermanent loss?

Liquidity providers cannot avoid impermanent loss completely. However, they can use some measures to mitigate this risk such as using stablecoin pairs and avoiding volatile pairs.

One strategy to avoid temporary loss is to choose stablecoin pairs that offer the best bet against IL since their value does not move much; they also have fewer arbitrage opportunities, lowering the risks. Liquidity providers using stablecoin pairs, on the other hand, are unable to gain from the bullish crypto market.

Choose pairs that do not expose liquidity to market instability and temporary loss rather than cryptos with an unstable history or high volatility. Another strategy to avoid temporary loss is to search the market, which is highly volatile thoroughly.

As a result, deposited assets are expected to fluctuate in value. Liquidity providers, on the other hand, must know when to sell their holdings before the price drifts too far from the starting rates.

As a result, significant financial institutions do not participate in liquidity pools due to the risk of a temporary loss of DeFi. However, if AMMs are to be widely adopted by individuals and enterprises around the world, this problem can be solved.

How does impermanent loss happen?

The difference between the LP tokens' value and the underlying tokens' theoretical value if they hadn't been paired leads to IL.

Let's look at a hypothetical situation to see how impermanent/temporary loss occurs. Suppose a liquidity provider with 10 ETH wants to offer liquidity to a 50/50 ETH/USDT pool. They'll need to deposit 10 ETH and 10,000 USDT in this scenario (assuming 1ETH = 1,000 USDT).

If the pool they commit to has a total asset value of 100,000 USDT (50 ETH and 50,000 USDT), their share will be equivalent to 20% using this simple equation = (20,000 USDT/ 100,000 USDT)*100 = 20%

Calculation of liquidity providers share in the liquidity pool

The percentage of a liquidity provider's participation in a pool is also substantial because when a liquidity provider commits or deposits their assets to a pool via a smart contract, they will instantly receive the liquidity pool's tokens. Liquidity providers can withdraw their portion of the pool (in this case, 20%) at any time using these tokens. So, can you lose money with an impermanent loss?

This is where the idea of IL enters the picture. Liquidity providers are susceptible to another layer of risk known as IL because they are entitled to a share of the pool rather than a definite quantity of tokens. As a result, it occurs when the value of your deposited assets changes from when you deposited them.

Please keep in mind that the larger the change, the more IL to which the liquidity provider will be exposed. The loss here refers to the fact that the dollar value of the withdrawal is lower than the dollar value of the deposit.

This loss is impermanent because no loss happens if the cryptocurrencies can return to the price (i.e., the same price when they were deposited on the AMM). And also, liquidity providers receive 100% of the trading fees that offset the risk exposure to impermanent loss.

How to calculate the impermanent loss?

In the example discussed above, the price of 1 ETH was 1,000 USDT at the time of deposit, but let's say the price doubles and 1 ETH starts trading at 2,000 USDT. Since an algorithm adjusts the pool, it uses a formula to manage assets.

The most basic and widely used is the constant product formula, which is being popularized by Uniswap. In simple terms, the formula states:

Constant product formula

Using figures from our example, based on 50 ETH and 50,000 USDT, we get:

50 * 50,000 = 2,500,000.

Similarly, the price of ETH in the pool can be obtained using the formula:

Token liquidity / ETH liquidity = ETH price,

i.e., 50,000 / 50 = 1,000.

Now the new price of 1 ETH= 2,000 USDT. Therefore,

Formula for ETH liquidity and Token liquidity

This can be verified using the same constant product formula:

ETH liquidity * token liquidity = 35.355 * 70, 710.6 = 2,500,000 (same value as before). So, now we have values as follows:

Old vs. New ETH and USDT values

If, at this time, the liquidity provider wishes to withdraw their assets from the pool, they will exchange their liquidity provider tokens for the 20% share they own. Then, taking their share from the updated amounts of each asset in the pool, they will get 7 ETH (i.e., 20% of 35 ETH) and 14,142 USDT (i.e., 20% of 70,710 USDT).

Now, the total value of assets withdrawn equals: (7 ETH * 2,000 USDT) 14,142 USDT = 28,142 USDT. If these assets could have been non-deposited to a liquidity pool, the owner would have earned 30,000 USDT [(10 ETH * 2,000 USDT) 10,000 USD].

This difference that can occur because of the way AMMs manage asset ratios is called an impermanent loss. In our impermanent loss examples:

Impermanent loss when the liquidity provider withdraws their share of 20%

What is impermanent loss protection?

Impermanent Loss Protection (ILP) is a type of insurance that protects liquidity providers from unexpected losses.

Liquidity provisioning is only profitable on typical AMMs if the benefits of farming surpass the cost of temporary loss. However, if the liquidity providers suffer losses, they can utilize ILP to protect themselves against impermanent loss.

To activate ILP, tokens must be staked on a farm. Let's use the example of the Bancor Network to understand how ILP works. When a user makes a new deposit, the insurance coverage provided by Bancor grows at a rate of 1% per day the stake is active, eventually reaching full range after 100 days.

Any temporary loss that happened in the first 100 days or at any time after that is covered at the time of withdrawal by the protocol. However, only partial IL compensation is available for withdrawals made before the 100-day maturity. For instance, after 40 days in the pool, withdrawals receive a 40% compensation for any temporary loss.

For stakes withdrawn within the first 30 days, there is no IL compensation; the LP is liable to the same IL they would have incurred in a conventional AMM.

What is an impermanent loss in yield farming?

When a token price rises or falls after you deposit it in a liquidity pool, this is known as crypto liquidity pools' impermanent loss (IL).

Yield farming, in which you lend your tokens to gain rewards, is directly related to impermanent loss. However, it is not the same as staking, as investors are required to inject money into the blockchain to validate transactions and blocks to earn staking rewards.

On the contrary, yield farming entails lending your tokens to a liquidity pool or providing liquidity. Depending on the protocol, the rewards vary. While yield farming is more profitable than holding, offering liquidity has its risks, including liquidation, control and price risks.

The number of liquidity providers and tokens in the liquidity pool defines the risk level of impermanent loss. The token is coupled with another token, usually a stablecoin such as Tether (USDT) and an Ethereum-based token like Ether (ETH). Pools with assets like stablecoins within a narrow price range will be less vulnerable to temporary losses. As a result, liquidity providers face a lower risk of impermanent loss with stablecoin in this scenario.

So, since liquidity providers on automated market makers (AMMs) are vulnerable to future losses, why do they continue to provide liquidity? It is because trading fees might compensate for the temporary loss. For instance, pools on Uniswap, which are highly susceptible to temporary loss, can be profitable due to trading fees (0.3%).

Liquidity