Impermanent Loss
Understanding Impermanent Loss is an important part of being a liquidity provider
A Quick Reminder!
If you are pooling in THORSwap, you will need to sell half of your RUNE to participate in a pool. There is not currently a RUNE:RUNE pool. You will no longer own 100% RUNE, and if the value of RUNE goes up while the value of the other asset in the pool is flat or negative, you see a decrease in your total RUNE-equivalent holdings compared to your original holdings. This is not impermanent loss. This is simply because a liquidity pool is an auto balancing portfolio between two assets, and you no longer own 50% of your RUNE, so you will experience the effects of the pool balancing. Always remember: you are now holding two assets.
An upcoming Synthetics feature will allow for single-sided LP with no impermanent loss.
Impermanent Loss Insurance
THORChain has implemented an impermanent loss insurance formula similar to Bancor for LPs that stake for >100 days.
What is Impermanent Loss?
A better term for Impermanent Loss is Divergent Loss. Since losses increase as the price difference between the two assets in a pool increase, this more accurately describes the effect. But, the term "impermanent" is more widely used, despite the fact that these losses can very easily become permanent.
Impermanent loss is the difference between holding tokens in your wallet versus staking them in a liquidity pool. When the value of tokens in the pool isn't stable, bots work to balance the ratio while profiting off of the price difference (arbitrage). This profit comes out of the pockets of liquidity providers.
Instead of adding a fixed-rate fee for every swap, THORChain adds a slip-based fee. This ensures that liquidity is incentivized exactly where it is needed. This reduces the risk of impermanent loss for liquidity providers on THORChain.
In addition, THORChain rewards LPs with network and liquidity incentives to offset the opportunity cost of impermanent loss. This lowers the risk of impermanent loss, and in some cases, makes it negligible. But, there is always a risk of loss when providing liquidity on any market.
You may see a drop in asset value on some days (especially volatile ones) when providing liquidity. Over time, you should average out -- but many factors play into the effects of impermanent loss, and it can be unpredictable as to whether you are better off holding, or providing liquidity.
TL;DR: The most "risk free" way to LP is to only enter pools with highly correlated assets -- the most obvious example is stablecoins, like USDT and DAI, or ETH and sETH, wBTC and rBTC, etc. That way, you get all the rewards/fees from being an LP, with little to no impermanent loss.
The potentially worst idea is to LP in a pool with highly uncorrelated assets For assets that are highly divergent, when one goes up, the other goes down. As an LP, you want a minimal amount price divergence. But, even if the 2 assets in the pool diverge significantly for a long period of time, if they eventually normalize, the impermanent loss will disappear (hence, the 'im'-permanent).
For example, BTC:ETH pool, where ETH does a 5x. You'll see a huge IL, but if months later BTC also 5x's, that IL will go away and you'll see a proper 5x on both assets, plus all your rewards/fee gains. That's the ideal situation, since volatility in a pool leads to more trades and more fees, but the risk of the impermanent loss becoming permanent is higher.
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