John Gilbert


<p>Investors often claim that you can’t see the full damage of impermanent loss until funds are withdrawn. According to the experts at Amberdata though, this isn’t the case. All data is open and measurable. Anyone can provide an estimate. The real challenge is finding a precise calculation and in analyzing the risk of impermanent loss versus the reward of transaction fees.&nbsp;</p>



<p>The complexity of data sources makes this analysis difficult to account for all investment strategies. But a review of the basics can provide the tools necessary for such a report.&nbsp;</p>



<p>We sat down with <a href="https://www.amberdata.io/?utm_campaign=2022-Q3-Blockworks-Investor-Guide&amp;utm_source=Report" target="_blank" rel="noreferrer noopener">Amberdata</a>, a leader in cryptoeconomic data, to better understand impermanent loss (IL) and how to navigate it. This guide will offer context to IL by explaining the technology behind automated market maker (AMM) liquidity pools. It will explain why it happens and why it is difficult to assess. And it will detail the data resources needed to detect clues before loss occurs.&nbsp;&nbsp;&nbsp;</p>



<h2 class="wp-block-heading">When does impermanent loss happen?</h2>



<p>Impermanent loss happens when the price of a token changes relative to its pair, between the time you deposit it in a liquidity pool and when you withdraw it.&nbsp;</p>



<p>Think of it as primarily an unrealized opportunity cost. It’s not a real loss, because the loss is measured against the value your investment would have been if the tokens were held outside of the liquidity pool. So if you are measuring your investment in cash, impermanent loss may not cause you to lose money. And it’s unrealized because token pairs can return to the same ratio before liquidity is withdrawn.&nbsp;</p>



<h2 class="wp-block-heading">Where does it occur?</h2>



<p>Impermanent loss can occur in any decentralized exchange (DEX) that uses liquidity providers to fund pools segregated by trading pairs. But before we explain the mathematical phenomenon of the loss, we need to explain the purpose behind this new type of exchange and how it works.&nbsp;&nbsp;&nbsp;&nbsp;</p>



<h2 class="wp-block-heading">Decentralized Exchanges</h2>



<h3 class="wp-block-heading">The purpose</h3>



<p>DEXs were created for people to swap different tokens without a trusted third party. Unlike a centralized exchange (CEX), assets remain in your wallet and the exchange never has custody of them. They use two blockchain-based innovations to maintain decentralization: automated market maker algorithms and liquidity pools.</p>



<h2 class="wp-block-heading">Automated Market Maker Algorithms&nbsp;</h2>



<p>An automated market maker algorithm is what sets the exchange rates for specific asset pairs within a DEX.&nbsp;&nbsp;</p>



<p>The traditional CEXs facilitate trades through an order book. Exchange rates are set when buyers create demand and sellers offer supply. The order book matches the price a buyer is willing to pay with the price a seller is willing to accept.</p>



<p>In contrast to setting prices to match buy and sell orders, AMM algorithms are programmed to automatically adjust exchange rates to keep the supply of paired tokens balanced within a pool.&nbsp;&nbsp;</p>



<h2 class="wp-block-heading">Liquidity Pools</h2>



<p>Liquidity pools are smart contract enforced deposits of two tokens needed to enable swaps on a DEX. These pairs are usually set at a 50/50 ratio (but there are also uneven liquidity pools).</p>



<h3 class="wp-block-heading">How they work</h3>



<p>Imagine that you are a brand new exchange looking to open a single pool for BTC and ETH. Before anyone is able to swap BTC for ETH or vice versa, you need to attract liquidity providers to the pool.&nbsp;</p>



<h4 class="wp-block-heading"><strong>The liquidity provider&nbsp;</strong></h4>



<p>Exchanges do this by first charging a fee for every swap and then sharing those fees as rewards with all liquidity providers in the pool. For example, if you provide 1% of the liquidity in a pool, you’ll receive 1% of the fees for that pool. Understanding the fee structure is critical to assessing the risk vs reward of adding liquidity. Because ultimately, the rewards from fees could more than offset the risk of impermanent loss.&nbsp;</p>



<p>In the ETH/BTC pool, a liquidity provider would need to include both tokens in their deposit. Most exchanges require a 1:1 ratio. So if a liquidity provider deposited 2 BTC and 1 BTC = 5 ETH, then you would need to match your BTC with 10 ETH. Once funds are deposited, you are given LP tokens as a representation of your percentage of the combined value of both tokens in the pool. LP tokens earn rewards from transaction fees and can be used to farm yield outside of the protocol.&nbsp;</p>



<h4 class="wp-block-heading"><strong>The trader</strong></h4>



<p>Now that you have attracted enough liquidity providers, traders can start swapping tokens. But unlike CEXs, traders can’t toggle between their preferred token or currency in a single pool. Instead, they are required to swap one token for the other. So everytime BTC is withdrawn, the equivalent in exchange rate value is added in ETH — and vice versa.&nbsp;</p>



<h4 class="wp-block-heading"><strong>How AMMs price tokens and balance liquidity pool</strong>s</h4>



<p>At a pool&#8217;s onset, AMMs use market rates to set prices and an equal balance in value between the supply of both tokens. So if 1 BTC = 5 ETH, total supply in the pool will reflect that ratio. As users swap tokens, the AMM uses a mathematic formula to adjust prices and balance the liquidity pool.&nbsp;</p>



<p>For example, say that there was initially 100 BTC and 500 ETH in the pool. The current price of BTC would therefore be 5 ETH. If you were to take 1 BTC for 5 ETH, the total supply would be 99 BTC and 505 ETH. This would change the price of BTC from 5 ETH to about 5.1 ETH.&nbsp;</p>



<p>But say market-wide, the price of BTC is still 5 ETH. Arbitrage traders would then take that opportunity to buy BTC at a discount and sell it for ETH in the liquidity pool. This arbitrage would continue until the price falls back to market rates.&nbsp;</p>



<h2 class="wp-block-heading">Examples of impermanent loss</h2>



<p>The ultimate cause of impermanent loss is unequal price changes. Though, it is important to remember that your return is calculated after collecting fees. So even if unequal price fluctuations cause impermanent loss, you may still be able to make a profit if rewards from transaction fees cover the difference.&nbsp;</p>



<p>For example, let’s say an ETH/BTC pool is programmed to keep the value of both baskets set at a 1:1 ratio. Meaning, the value of all BTC should be the same as all ETH. At the time of your deposit, 1 BTC equals 10 ETH across most other exchanges, so you deposit 4 BTC and 40 ETH.&nbsp;</p>



<p>At the time of depositing the tokens, the size of the pool was 20 BTC and 200 ETH, so your total share of liquidity is 20%.&nbsp;</p>



<p>A month later, <strong>ETH doubled in value while BTC’s price stayed the same.</strong> But the value of both token baskets in the pool don’t yet reflect the ETH market-wide price of .2 BTC. So arbitrage traders rush in to buy ETH at the discount until the pool ratio and token prices match the market rate.&nbsp;</p>



<p>So once the pool supply reaches 20 BTC and 100 ETH, your 20% deposit will be worth 4 BTC and 20 ETH. That is a 20 ETH price difference from the initial 40 ETH deposit, resulting in an impermanent loss of 20 ETH. But it just so happened that transaction fees were extraordinarily high, providing an additional 10 ETH to your share of the pool. In this case, the loss on your return would only be 10 ETH at market value. It is impermanent because the supply of tokens in the pool can return to a 1 BTC to 10 ETH ratio in the future. The loss becomes permanent once funds are withdrawn from the pool. But if a liquidity provider gains enough exposure, rewards from transaction fees can potentially make up for the impermanent loss.&nbsp;</p>



<h2 class="wp-block-heading">Is impermanent loss actually difficult to spot?</h2>



<p>The reason many find it difficult to spot impermanent loss isn’t because it is an inherent mystery &#8211; it is a calculable math problem. The team at Amberdata explained that due to its complexity, most resources only provide estimates.&nbsp;</p>



<p>Say that you use your LP tokens in a yield farming endeavor that generates rewards on another protocol. Estimates on the exchange can’t account for those rewards. So even if it is showing impermanent loss, it could be that your yield farming endeavor makes back the loss.&nbsp;&nbsp;</p>



<p>A full assessment requires multiple data points, but if you have a clear view of what&#8217;s needed, that calculation can be precise and provide actionable investing data.</p>



<p>Plus, IL is different for everyone because portfolios have a different mix of tokens pairs. People also don’t deposit and withdraw at the same times or prices.</p>



<p>To calculate PnL for a liquidity position, you need data on:</p>



<ul><li>Each token’s price at deposit</li><li>The amount of each token deposited</li><li>Date of deposit</li><li>Rate of reward for the liquidity pool</li><li>Estimated price of each token at withdrawal</li><li>Date of withdrawal</li><li>LP token yield farming strategies&nbsp;</li></ul>



<p>Because there are so many variables in calculating the difference between projected gains from holding tokens versus LP fees, many struggle to make a useful conclusion about whether to enter or exit a liquidity pool.</p>



<p>As an added complication, the risk and reward is different for every token pair depending on each one&#8217;s volatility. The more diverse the portfolio, the more difficult this becomes.</p>



<h2 class="wp-block-heading">How to calculate impermanent loss</h2>



<p>There are detailed mathematical explanations for how to calculate IL, but in brief, a formula can be used. IL increases the more an asset’s price changes relative to its pair. This is plotted on a graph.</p>



<p>In this very simplified example, you can see that IL happens whether prices go up or down. But the loss is much greater as a token&#8217;s price goes down. This causes many liquidity providers to look for token pairs that are likely to appreciate at a similar rate over time.</p>


<div class="wp-block-image">
<figure class="aligncenter size-full"><img loading="lazy" decoding="async" width="926" height="514" src="https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png" alt="" class="wp-image-25712" srcset="https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=926 926w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=300 300w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=768 768w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=428 428w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=470 470w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=389 389w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=80 80w, https://blockworks-co.imgix.net/wp-content/uploads/2022/08/Amberdata.png?w=50 50w" sizes="(max-width: 926px) 100vw, 926px" /></figure></div>


<h2 class="wp-block-heading"><a href="https://www.amberdata.io/?utm_campaign=2022-Q3-Blockworks-Investor-Guide&amp;utm_source=Report"></a><strong>Can you avoid impermanent loss?</strong></h2>



<p>Since impermanent loss is triggered by unequal prices changes, the best way to avoid it is by avoiding volatile token pairs. But Amberdata stresses that there are always a wide array of investment choices in a cost-benefit analysis. For example, simply avoiding IL may not make sense when you measure a pool’s IL costs vs transaction fee rewards. The most informed decision evaluates the potential return in relation to other pools and opportunities. This comprehensive approach helps the liquidity provider find alpha.</p>



<p>In our conversation, Amberdata said that they offer their clients comprehensive insights across decentralized finance, and can quantify historical performance in context to other liquidity pools and investment strategies. They provide the data needed for a full risk/reward assessment that ultimately informs liquidity providers in their search for alpha.&nbsp;</p>



<p>One of the most useful tools for providing liquidity is <a href="https://www.amberdata.io/?utm_campaign=2022-Q3-Blockworks-Investor-Guide&amp;utm_source=Report">Amberdata’s impermanent loss endpoint</a>. With it, liquidity providers can get the exact data needed to evaluate IL risk for token pairs in specific liquidity pools on different DEXs.&nbsp;</p>



<h3 class="wp-block-heading">Why comprehensive data is important</h3>



<p>Amberdata said that their endpoint tools don’t take shortcuts when it comes to calculating impermanent loss. Their application collects liquidity pool data from across exchanges and tracks activity to get accurate, customized calculations.&nbsp;</p>



<p>For example, many IL calculations do not account for the mints and burns that a liquidity provider may make in a single day. Minting refers to the LP tokens that are created when funds are deposited. Those tokens are then burned when funds are withdrawn. Liquidity providers will often try to time minting and burning to avoid volatile price swings in a pool. If their IL estimate is only a 24 hour snapshot of what impermanent loss would be from the start to the close of the day, then they will not be able to measure the impact of their liquidity positions. Amberdata takes those intraday mints and burns into consideration when calculating IL.&nbsp;</p>



<p>While the precision of an IL calculation is critical, it doesn’t provide the full story. Even if a liquidity provider is able to avoid IL through savvy burning and minting practices, it doesn’t mean that they maximized return. Effective back-testing of liquidity provider strategies requires comprehensive data points that detail the potential transaction fee rewards when an LP is in and out of a position. Amberdata said that they built their services so that liquidity providers could use this comprehensive approach to put their best strategies forward.</p>



<p><em>This post is sponsored by <a href="https://www.amberdata.io/?utm_campaign=2022-Q3-Blockworks-Investor-Guide&amp;utm_source=Report" target="_blank" rel="noreferrer noopener">Amberdata</a>.</em></p>



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The Investor’s Guide to Navigating Impermanent Loss

Casey Wagner

<div id="highlights-block_62605237d88d8" class="highlights">
        <ul>
                <li>Transactions of more than $10 million became the largest segment of DeFi transactions by volume</li>
                <li>Hackers made off with $3.2 billion in cryptocurrency in 2021, according to Chainanalysis</li>
            </ul>
    
</div>



<p>Total value locked in DeFi increased from $601 million at the start of 2020 to $239 billion so far in 2022, a nearly 40,000% rise, according to a new research <a href="https://blog.amberdata.io/defi-and-the-transformation-of-institutional-finance?utm_medium=email&amp;_hsmi=210559080&amp;_hsenc=p2ANqtz--4jBnJwnHdMtyADjUnlFmz3EWc60XJyaMGdl1NYqYtV3SX4KRwULMEajGaUK9DCcdv2vEuHTmoCtizJjEAq1tmaLmMOQ&amp;utm_content=210559080&amp;utm_source=hs_email" target="_blank" rel="noreferrer noopener">report</a>.</p>



<p>The report’s author, blockchain data provider Amberdata, said the massive rise is “still in the early stages,” adding that total value locked (TVL) should “increase dramatically” in the next few years as institutions enter the market.</p>



<p>Large institutional transactions, which blockchain analytics company Chainalysis defines as above $10 million, became the biggest segment of DeFi (decentralized finance) trades by volume beginning in the fourth quarter of 2020 and grew to over 60% of transaction volume by the second quarter of 2021, according to the company.&nbsp;</p>



<p>Even as more capital floods DeFi protocols, the industry remains vulnerable to hacks. In 2021, hackers made off with $3.2 billion in cryptocurrency, according to Chainanalysis <a href="https://blog.chainalysis.com/reports/2022-defi-hacks/" target="_blank" rel="noreferrer noopener">data</a>.</p>



<p>Ronin Network, an Ethereum-linked sidechain used for blockchain gaming group Axie Infinity, was <a href="https://cms.blockworks.co/sky-mavis-ronin-network-bridge-exploited-for-over-600m/" target="_blank" rel="noreferrer noopener">breached</a> in late March for roughly $600 million, or <a href="https://etherscan.io/address/0x098b716b8aaf21512996dc57eb0615e2383e2f96" target="_blank" rel="noreferrer noopener">173,600 ether</a>, as well as $25.5 million USDC. <a href="https://cms.blockworks.co/treasury-sanctions-north-korean-hacker-group-confirms-ties-to-625m-hack/" target="_blank" rel="noreferrer noopener">Federal investigators</a> later confirmed that North Korea-based hacker Lazarus Group led the hack.</p>



<p>DeFi protocol <a href="https://cms.blockworks.co/wormhole-parent-commits-320m-ether-to-replace-massive-defi-hack-losses/" target="_blank" rel="noreferrer noopener">Wormhole</a> suffered a $326 million hack in February — then the second-largest such incident to date. The largest hack in DeFi, and all of crypto, is still the August 2021 $600 million Poly Network hack.</p>



<p>The crime was attributed to a figure that went by the name “Mr. White Hat,” who, <a href="https://cms.blockworks.co/poly-network-offers-chief-security-officer-role-to-hacker-that-stole-600m/" target="_blank" rel="noreferrer noopener">in an interesting turn of events</a>, was later offered a security position at the interoperability protocol.</p>



<p>Despite mounting security concerns, researchers at Amberdata insist use cases for DeFi technology are only just emerging, particularly when it comes to financial infrastructure and efficiency.&nbsp;</p>



<p>DeFi can offer new solutions for data storage, meaning financial services companies could save resources on infrastructure development, the Amberdata report said.&nbsp;</p>



<p>“For example, a retail bank that maintains ATMs and branches needs to maintain data connections between those endpoints, its corporate offices, and the data center(s) where that data is stored,” researchers wrote. “This bank could leverage a DeFi solution on a private blockchain that reduces data center needs only to what is necessary to maintain blockchain nodes.”</p>



<p>DeFi-enabled smart contracts can also speed settlement times and support complex financial transactions, researchers added.</p>



<p>“In 2021, the global financial services market was estimated to be worth more than $23.3 trillion, meaning that at present, DeFi accounts for about 1% of the total,” the report said. “An increase to just 5% would see over a trillion dollars flow into the space.”</p>



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Large Institutional Transactions Push Total Value Locked in DeFi to $239B

Jacquelyn Melinek

<div id="highlights-block_613fd2e5dafc1" class="highlights">
        <ul>
                <li>In 2017, Amberdata closed a Series Seed round for $2 million and has raised a cumulative amount of $17 million to date</li>
                <li>“There’s this tsunami that’s happening around digital assets,” Douglass said. There’s a massive demand from institutional investors to learn about digital assets and adapt to it, he added.</li>
            </ul>
    
</div>



<p>Digital asset data company Amberdata announced it has raised $15 million in a Series A funding round led by Citi.&nbsp;</p>



<p>Participants in this investment round also includes Franklin Templeton, Galaxy Digital, Rovida Kruptos Assets, executives at GoldenTree Asset Management as well as HWVP, who previously led Amberdata’s Series Seed round.&nbsp;</p>



<p>In 2017, Amberdata closed a Series Seed round for $2 million and has raised a cumulative amount of $17 million to date, Shawn Douglass, CEO at Amberdata said in an interview with Blockworks. The company is not disclosing a valuation at this time, he said.&nbsp;</p>



<p>The company will use the funds to double research and development headcount and expand go-to-market both in the US and internationally, the company said. Amberdata plans to expand its research and development further into decentralized exchanges, DeFi and understanding money flows in stablecoins, Douglass said.&nbsp;</p>



<p>“There’s this tsunami that’s happening around digital assets,” Douglass said. There’s a massive demand from institutional investors to learn about digital assets and adapt to it, he added.</p>



<p>Institutional investors are seeing demand from their customers, Tongtong Gong, chief operating officer at Amberdata told Blockworks. “Companies are looking at the fundamental value and must have an understanding of it because when they get into it they need high quality data to understand the space,” she added.</p>



<p>&#8220;Financial institutions and global payment providers are increasingly interested in offering cryptocurrency-enabled products and services,&#8221; said Chris Ferraro, co-president and CIO at Galaxy Digital.</p>



<p>Amberdata is a four-year-old company that analyzes over 8 million blockchain network transactions and around $500 billion in trading activities daily. Its platform provides financial institutions entering the digital asset market with data for research, trading, risk, analytics, reporting and compliance, it said.&nbsp;</p>



<p>“Data and insights will continue to play a pivotal role in creating transparency and strengthening risk management frameworks for digital assets,” said Siris Singh, Americas head of markets strategic investments at Citi. “We are excited to be leading their Series A and supporting the team on their next phase of growth.&#8221;</p>



<p><strong>Are you a UK or EU reader that can&#8217;t get enough investor-focused content on digital assets?<a target="_blank" href="https://cms.blockworks.co/events/das-london/" rel="noreferrer noopener">Join us</a> in London on November 15th and 16th for the Digital Asset Summit (DAS) London. Use code ARTICLE for £75 off your ticket. <a target="_blank" href="https://cms.blockworks.co/events/das-london/" rel="noreferrer noopener">Buy it now</a>.</strong></p>
