Given the fact of how fast decentralized finance evolves, it becomes exponentially harder to keep the track of all the risks involved. One of those risks is called impermanent loss and is directly related to AMM.
Crypto Industry has seen a lot of growth in the last year, defi obviously leading the way while the number of experiments regarding decentralized finance just keeps growing.
There's a problem though.
The only way to verify how will the market react under certain conditions is to let it free. Unfortunately, open-source projects are the most vulnerable and get exploited more often. Not only due to the decentralized nature of such platforms, rather due to inbuilt flaws no one counted on.
The white paper is a theory and it often behaves differently than expected. Human behavior is unpredictable as we tend to become emotional without even realizing it.
AMM tech has been quite successful, irreversibly transformed the game of providing liquidity in a decentralized and trustless manner while sharing the fee provision with the LPs. It has, however, a defect that needs to be dealt with differently, otherwise, the progress will decrease over time, that's for sure.
The risk of under-performing a basic hold strategy can be pretty messy and is the biggest problem AMMs are currently facing. It means that if you hold your tokens in AMM instead of a native wallet, there is a chance that you actually lose money, regardless of the rise in the value of that same token on other exchanges.
It occurs when the price of tokens inside an AMM diverge in any direction. The more divergence the greater the impermanent loss.
In essence, impermanent loss can be described as a temporary loss of money which occurred as a direct result of providing liquidity, thus differs itself from simply holding tokens on the native wallet.
But how exactly does AMM work?
In their raw form, AMMs are disconnected from external markets. If token prices change on external markets, an AMM doesn’t automatically adjust its prices. It requires an arbitrageur to come along and buy the underpriced asset or sell the overpriced asset until prices offered by the AMM match external markets.
During this process, the profit extracted by arbitrageurs is effectively removed from the pockets of liquidity providers, resulting in impermanent loss.
Probably the best illustration of how it works in practice.
The idea of AMMs is to allow Liquidity providers, lenders, and borrowers to form an economy that doesn't need an intermediary to regulate demand or interest rates. Those functions are given to the stakeholders which have a responsibility to make the most robust and secure technology without compromising decentralization.
Hope you find something useful.
