Now that CUB is launched, and many are flocking to participate the bountiful rewards, what are the risks of providing liquidity? many will know impermanent loss is the main risk. So what is impermanent loss?
by providing crypto to a liquidity pool, the liquidity provider deposits two crypto coins. The automated marker maker algorithms use mechanisms to provide exchange of the coins. lets run through an example to see how it works
Assume two coins, one is USD, and the other is Crypto.
Today the price of the Crypto coin is $1, and the pool has $1000 in it, so 1000 crypto coins. The total value of the pool is $2000 our contribution to the pool is $10 and 10 crypto (total $20 USD worth) or 1%.
If the price increases to $2, arbitrage investors will take advantage of the pool, and start exchanging USD for the crypto, initially at 1$, but the price will eventually rise to the market price. In the process additional USD will be deposited into the pool and Crypto coin would be withdrawn.
The equilibrium will eventually settle at $1333 USD and 667 Cyrpto coin. Why does it settle at this amount? because the total number of coins is fixed at 2000, and 1 Crypto coin now equals $2.
So lets withdraw our share, we have 1% of the pool, so that means we receive $13.33USD and 6.67 crypto coin. This is worth $26.67 in total, and increase of 33% (not bad!). However what happens if we just held the same assets outside the pool (i.e. HODL)? We would have $10USD and 10 Crypto coins (worth $20USD) with a total value of $30USD, a return of 50%. The difference between the HODL and Liquidity amount is the impermanent loss (i.e. $3.33 in this example)
If we apply the same example to the price falling to $0.50, we would have 667USD and 1333 crypto coin. with 1% of the pool we would have $6.67USD and 13.33 crypto coins. This is worth $13.33 in total, a loss of 33.33%. If we held the assets (i.e. HODL) we would have $15USD worth (a loss of 25%). The impermanent loss in this case is $1.67.
the above examples show that no matter which way the price moves there would be an impermanent loss, this doesn't allow for the complication of the liquidity pool changing in size as investors deposit or withdraw liquidity, but that will be ignored for now. So to answer the question of this article, yes impermanent loss is inevitable.
the examples above didn't include fees, and a liquidity pool charges a fee (often small like 0.3%) and provides that fee to the pool. So an investor depositing into a liquidity pool is expecting the fees to outweigh the impermanent loss. So this sounds great for stable coin liquidity pools that don't vary too much, but what about highly volatile and speculative coins? perhaps CUB?
Well that's where farming comes in, where rewards are provided for providing liquidity, with the expectation the rewards will outweigh the impermanent loss. Many liquidity pools use their own governance token (like CUB) to reward their liquidity providers usually funded through inflation. So farms are now yielding well in excess of 100% on the CUB defi platform. So when should you invest? well when you think the price of the coins will not increase or decrease substantially offsetting any yield gains.
