The introduction of decentralized finance, or DeFi, represents a significant turning point in the transformation of the financial industry as it provides an opportunity for end-users to have access to a wide variety of financial services independently of any centralized institutions. Where DeFi is found to introduce exciting revenue opportunities, it also presents unique risks. Volatility is one of the major issues with DeFi for liquidity providers; this might cost you some of your capital because you lose on account of the fluctuation in the market price of the assets you have invested. This article discusses non-temporary loss, the causes leading to it, and several strategies that can help reduce it completely or avoid it in DeFi protocols altogether.
Understanding Non-Permanent Damage
Non-pausable loss is the condition where the value of the assets in the liquidity pool has been different from what would have been acquired if you had held those in your wallet. This is most relevant in AMM models because one would place two assets into a pool. The primary function of these pools is to aid decentralized trading and provide liquidity.
If and when the price of a ratio of two assets in a pool fluctuates then there is a possibility for a discrepancy between the pool’s assets and their original value. The result is referred to as the non-permanent loss. This term “non-permanent” has been utilized here because theoretically, if the asset prices revert back to the original ratio, then the loss disappears. That can only occur if one were to sit back theoretically and not touch the money whereas the price hasn’t recovered yet. However, if an LP withdraws its funds before the price recovers then the loss becomes permanent.
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Factors that contribute towards permanent damage
Non-permanent losses bear a direct proportion to price fluctuations. The main points are as follows:
Asset prices volatility: the greater the volatility of two assets in the pool, the greater the permanent loss.
Liquidity Pool design: permanent loss is more probable in pools that have an equal asset ratio, like 50/50. Those having ratios differ from this, such as 80/20 or stablecoin pools, have fewer potential unsustainable losses.
In the pool: The more time your assets spend in the pool, the more vulnerable they will be to price movements and, by extension, permanent losses.
Non-permanent loss calculation
The loss of non-permanent is not linear but becomes somewhat out of proportion with changes in asset prices. For example,
Price increase multiplier 1.25x = 0.6% non-permanent loss
1.5x = 2% non-permanent loss
2x = 5.7% non-permanent loss
3x = 13.4% unsustainable loss
Even slight changes can significantly influence an asset, and hence LPs should sufficiently consider the permanent damage risk before sending their assets into the pool.
Methods of non-permanent loss prevention or lessening
Permanent damage is a risk of defecation by nature; however there are some strategies you can use to avoid it or prevent it.
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Select those pairs that have low volatility.
One of the best ways to prevent losses from volatility is to provide liquidity to pools of less volatile assets. Pools whose assets tend to move together, such as DAI/USDC and WBTC/ETH, present fewer chances for permanent loss because they are unlikely to have high price fluctuations. It’s particularly advantageous to use stablecoin pools, given their relatively constant values.
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Utilize non-permanent damage prevention protocols.
Some DeFi protocols have implemented loss prevention mechanisms that are not permanent. One such feature is provided by Bancor Network, which guarantees 100% protection against a loss that is not permanent if LPs remain in the pool for at least 100 days. In this kind of protection, you get it gradually as the time you remain increases. These protocols are ideal for users who intend to keep their assets in a liquidity pool for a long period.
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Single-sided stackings poles.
Single-sided staking allows pool contributions through a single type of asset. These include platforms such as Balancer, which permit this and significantly lower volatile losses since there is only one asset that requires balancing, rather than two. Although the two-asset pools may offer a higher return, these single assets could be the safer investment choice for investors who simply cannot stand volatility.
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Track markets and use stop loss tools
Monitoring the market and using stop loss tools can help manage risk much better. If one of the assets in your liquidity pool appreciates rapidly, then it makes more sense to withdraw some funds or rebalance your portfolio. While this contradicts what a “passive income” blockchain strategy is supposed to be, market tracking and rebalancing can be useful for volatile assets.
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Invest in protocols with flexible ratios.
Some DeFi platforms, such as Balancer, allow LPs to set asymmetric pool ratios, for instance 80/20 or 90/10 instead of 50/50. With those, the risk of non-permanent loss is reduced because rebalancing the pool is less frequently required. For example, 80% ETH and 20% DAI will not create the same issue where ETH price movements could radically debase the pool value like a 50/50 ETH/DAI pool would.
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Employ a layer 2 solution.
Layer 2 solutions, like Arbitrum or Optimism, decrease the cost of the transaction which enables LPs to respond fast to changes in the market. Although high gas prices inhibit LPs from adjusting their positions in real time based on changes within the market, more favorable lower transaction fees through application of Layer 2 solutions enable rebalancing or withdrawal of your funds in time.
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Yield farming and stacking incentives.
At times, the rewards from yield farming or stocking offset the permanent loss. If the rewards get to a certain level of value, one can afford some non-permanent loss. Calculate if the ROI is higher than the loss of rewards.
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Use DeFi Insurance
As a new area of business, DeFi insurance is becoming increasingly offered by companies such as Nexus Mutual and Cover Protocol. These covers may not necessarily prevent you from suffering permanent damage, but they will protect you from other possible risks such as hacks and exploits on contracts and protocols. This will leave you time to deliberate over ways of mitigating permanent damage better.
How to select the perfect pools for minimizing permanent damage.
There are hundreds of options, and it gets really tough to shortlist one. Here is what you need to do for the right pools:
Learn from the historical volatility: While planning to pool your assets, look at how volatile the assets have been historically in the pool. You can use tools like Coingecko or CoinMarketCap to check if the assets are highly volatile.
Anassess Protocol Features: Certain DeFi protocols offer special features, such as fee-sharing mechanisms or protection against non-permanent losses, which can potentially modify the overall net profit LPs will generate.
Compute possible impermanent loss: Calculators for impermanent loss are available on many of the most well-known DeFi analytics platforms, like DeFi Pulse or Zapper.fi. These calculators will thus help you simulate a potential amount of nonpermanent loss you might incur under different price scenarios.
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The outcome
Volatile loss is one of the risk that liquidity providers should be aware of, particularly while offering liquidity in volatile markets. However, with good planning and risk management, you manage to reduce it in some instances while avoiding it in most cases. This is achieved by choosing low-volatility pairs, continuous search for consistent loss protection, or even implementing flexible ratio pools with constant monitoring of the market.
The DeFi space is changing with the seconds that pass, and new solutions emerge permanently to deal with permanent damage. By reading this article and applying the strategies learned, you will maximize DeFi income with minimal permanent losses.
