Impermanent loss is a death sentence for DeFi mining 🚨 This article is 4 years old...
Impermanent loss is a death sentence for DeFi mining
3 min read
Updated: Feb. 23, 2021 at 10:47 am UTC
Cover art/illustration via CryptoSlate. Image includes combined content which may include AI-generated content.
Decentralized finance is a prevalent industry that keeps reaching new milestones. Despite the appeal, no one can deny plenty of issues with the current DeFi mining model. In my opinion, we need to revamp this entire aspect by removing impermanent loss from the equation.
DeFi Mining Has Issues
One of the more popular aspects of decentralized finance today is the option to engage in liquidity mining. Every cryptocurrency user wants to earn a passive revenue stream by owning the right tokens. In this day and age, these tokens’ requirements are less strict than a few months ago. Many opportunities exist to engage in DeFi mining these days, yet there are certain risks.
Even though there is plenty of Total Value Locked in DeFi mining solutions today, the users are exposed to many risks. This doesn’t deter Uniswap or Sushiswap users, contributing to $4.47 billion and $3.85 billion in liquidity mining today. Some of these problems can be mitigated a bit, but others will require upgrading the entire decentralized finance infrastructure.
A new solution needs to be found rather than exposing users to impermanent loss while engaging in DeFi liquidity mining. After spending some time glancing over many whitepapers, one particular concept stands out to me. Introducing such measures is a crucial first step to take DeFi into the mainstream. If the risk factor is lowered by several degrees, more people will prove willing to contribute overall liquidity.
The Impermanent Loss Factor
Impermanent loss is an aspect of decentralized finance that one cannot always avoid. Providing liquidity to a liquidity pool to mine rewards seems viable on paper, but the outcome can differ. I made the mistake of underestimating impermanent loss in the beginning and paid the price for it. Most people seem unaware that this aspect even exists today.
When holding an asset, and the prices go up, a trader or speculator makes a direct profit if they sell at that value. As their asset is liquid, it is easy to move it to a trading platform and complete a transaction. However, when using such assets for DeFi mining, one often needs to provide a “counter asset” to the liquidity pool. This can be another cryptocurrency, token, or stablecoin.
If one asset in the liquidity pool rises in value, arbitrage traders will have to ensure the pool price reflects the current prices and maintain a balance. As a result, your token rising in profit will have its “gains” stripped nearly entirely as balance is restored. Even when you withdraw liquidity, you will face a “loss” compared to benefiting from a value appreciation by holding the asset.
If there is one thing I learned from dealing with impermanent loss, HODLING is often the best approach. That is, until I came across a solution that may put any thoughts regarding permanent loss to an end.
The Single-Token Approach
In the whitepaper produced by SIL Finance, the team proposes a way to remove impermanent loss once and for all. Rather than forcing users to supply two sides of liquidity to a pool, the team suggests depositing funds in exchange for tokens. Every token can be staked in an eligible pool and serve as one-sided liquidity. This single-token mining approach uses a matching system to ensure a liquidity balance in every pool.
By pairing liquidity providers automatically, users can claim their profit from the smart contact at all times. Moreover, the whitepaper indicates how users who claim rewards can convert it into two tokens with a new LP pair and stake again if they want to. Empowering users is a crucial aspect of DeFi, yet it is overlooked far too often these days.
To ensure fairness, this single-token liquidity will only grant half of the liquidity pool’s profit to users. Combined with a robust multi-tier solution, those who engage in DeFi mining early on will have a more secure position in the Priority Queue. Liquidity providers will earn a profit from the trading commission and compound their interest if they reform into new LP assets.
Closing Thoughts
As a proponent of decentralized finance, it is evident this industry has tremendous potential. However, unlocking that potential requires building a better, more stable, and less risky infrastructure than we have today. Purposefully exposing users to impermanent loss is no longer a valid option, and all AMMs will have to adapt or perish a new model.
While I believe this single-token liquidity approach has many merits, it may not necessarily be the ultimate solution. Compared to impermanent loss, SIL Finance’s idea provides many benefits that would otherwise not exist. Solutions like these give me hope that, one day, decentralized finance will replace traditional products and services.
Posted In: DeFi, Guest Post
