This post is to help everyone explain Impermanent Loss and help those in deciding wether liquidity pools are for you!
So we will be using a DEC:SPS pool as our example since this is most relatable to Splinterland's players and it's how you can gain those Double Airdrop Point's. We are going to be using our own values for DEC/SPS to make the calculations easier. In our example DEC = $1 and SPS = $100. We’ll also say the liquidity pool for that pair is 1000DEC:10SPS. You decide to pair these two tokens using $100 worth of each. So you use 100DEC:1SPS. The total liquidity is 10,000 because: 1000DEC X 10SPS = 10,000 Your liquidity pair makes up 10% of the liquidity pool.
example
Now then, over time, the value of these coins will change on the regular market but, remain unchanged in the liquidity pool. Regardless of that value changing, the ratio of the liquidity pool must remain the same. In addition to that, the value of the coins must match the market price but, since the liquidity pool is unaffected by the open market, the values must be adjusted manually. This process is called arbitrage. An arbitrageur is a type of investor who attempts to profit from market inefficiencies. So it’s up to the Arbitrageurs to make sure that liquidity pools ratio remains constant and coin value is adjusted to reflect market price when removed. To do this, they have to add or remove tokens as necessary to ensure the values are the same. The one constant, is that the value of the entire liquidity pool remains the same.
So, if SPS goes up to $400 a token, that means the value of the SPS in the pool must be increased as well while keeping the ratio the same. Arbitrageurs will remove SPS and add DEC to the pool to correct it. Remember, the ratio and value of the entire pool must remain constant. So, they remove 5 SPS but, this also means they have to add 2000 DEC. 2000DEC X 5SPS = 10,000 or $2,000DEC : $2,000 SPS (50:50) Because the liquidity pools themselves are unchanged by market movements, this is the only way to maintain the value and ratio. They dilute the pool with DEC and remove SPS to maintain a 50:50 ratio and a liquidity pool value of 10,000. The removed SPS belongs to the Arbitrageurs now and this is how they make their profit.
Let’s say, at this point, you decide to remove your coins. Remember, you make up 10% of the liquidity pool and now the pool is made up of 2000DEC:5SPS. 10% DEC = 200 10% SPS = 0.5 So, when removed, you receive 200 DEC and .5 SPS. You’ve lost SPS, but gained DEC (and this is what most people consider the impermanent loss made permanent but, it’s not). So, since SPS has gone up to $400 a unit, your .5 SPS is worth $200 and; since DEC remains unchanged at $1 a unit, your 200 DEC is worth $200: $200 + $200 = $400 So you’ve made $200 in profit (this is not including your rewards for providing liquidity in the first place).
Now let’s say you hadn’t provided liquidity and just held onto your coins. You had 1 SPS and 100 DEC. Your 1 SPS is worth $400 and your DEC is worth $100: $400 + $100 = $500 You would have earned $100 more if you had just held. Impermanent loss = $100 or 20% less than what you would have earned by holding. The difference between these two numbers is your impermanent loss made permanent.
So, in this case, we’re dealing with one value increasing and another value remaining constant. The flip side of it is when a coin loses value or increases too much in value. The ratio and value of the liquidity pool must remain constant so, your impermanent loss will be much more dramatic when one coin falls and the other remains the same (or rises too far). That’s why the apy on the lesser known coins is so high. The arbitragers are counting on you pairing that lesser known token with a more stable one. They’ll flood the regular market with more of the lesser known coins so that the value decreases, which means removing the more stable coin from the liquidity pool while adding more of the lesser known coin to maintain those values. They want to remove the better coin because they’ll make more profit. So, high apy is associated more with risk than with value. Hopefully this wasn’t too convoluted, sorry so long.
DISCLAIMER
This content is mostly the below author's and I give full credit to them as I am no expert on Impermanent Loss. I have altered their content to make it more fit for our situation. You can view their profiles on reddit and find the specific post related to this.
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https://www.reddit.com/user/metrimeio/
https://www.reddit.com/user/siflbabyshifero/
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