In DeFi, it’s important to understand what a liquidity pool is.
Liquidity pools are a key component of many DeFi protocols. They are essentially pools of tokens locked in a smart contract that provide the necessary liquidity for various DEXes and other DeFi platforms.
In typical liquidity pools, particularly those involving token pairs like ETH/BTC, liquidity providers contribute an equal value of each token, maintaining a fixed ratio such as 50% Token A (ETH) and 50% Token B (BTC) by value. This balanced contribution is essential in sustaining a stable market for the tokens within the platform.
As a reward for providing this liquidity and facilitating smooth market operations, these providers are compensated with a fee, usually around 0.2%, from the trades executed within the pool.
How Does Impermanent Loss Occur?
A major risk that liquidity providers face is called “Impermanent Loss”. This happens when the value ratio of the tokens in the pool changes after they’ve been added. If there’s a significant shift in the price ratio, it can lead to the total value of a provider’s deposit being lower than if they had kept their assets outside the pool. The term ‘impermanent’ loss is used because it becomes an actual loss only when the provider withdraws their assets at the changed price ratio.
Let’s explore this with an example:
- Assume you deposit an equal value of ETH and BTC into a liquidity pool, say, when 1 ETH equals 1 BTC.
- After your deposit, let’s say the market price of ETH increases relative to BTC. Now, 1 ETH is worth 1.5 BTC in the open market.
- Liquidity pools operate on certain algorithms (like the Constant Product Market Maker model) to determine the price of assets within the pool. When the market price outside the pool deviates from the price within the pool, it creates an opportunity for arbitrageurs. They will buy the cheaper ETH and sell the more expensive BTC in the pool until the pool’s price aligns with the market price. This action changes the ratio of ETH to BTC in the pool.
- As the pool’s ratio adjusts, you end up with more BTC and less ETH than you originally deposited. The value of your deposit in the pool is now different from its value if you had just held onto your ETH and BTC outside the pool.
Liquidity Mining or Farming
To address impermanent loss, some protocols have introduced mechanisms involving incentives, creating what we know as Liquidity Mining or Farming. These mechanisms are designed to generate additional revenue and combat impermanent loss.
Liquidity Mining, also known as Farming, is a way some DeFi protocols encourage users to provide liquidity (i.e., deposit their tokens) by offering them additional rewards.
Purpose: This method is used to attract more liquidity providers to help reduce the impact of impermanent loss, a risk where the value of deposited tokens in a liquidity pool might decrease.
However, the introduction of Liquidity Mining as a solution to combat impermanent loss has led to a new challenge: Token inflation.
This issue arises because protocols issue and distribute new tokens as incentives to reward liquidity providers, leading to an increase in the total number of tokens in circulation. As these additional tokens enter the market, they often face selling pressure, as many choose to sell them for other assets. This selling pressure tends to decrease the tokens’ value, necessitating even more incentives to maintain liquidity. Consequently, this can create a cycle where the continuous issuance of more tokens further exacerbates the decline in their value, leading to what is known as a “death spiral” in their price.
The introduction of Vaults in Yearn Finance by Andre Cronje was a direct response to the challenges of token inflation in liquidity mining. These challenges arose as protocols issued additional tokens as rewards to liquidity providers, leading to an oversupply and subsequent decrease in token value. To mitigate this, Yearn Finance Vaults were designed to automatically sell the reward tokens accumulated through liquidity mining, compounding the returns on the principal. This innovation not only helped in managing the inflationary pressure on tokens but also marked the beginning of structured financial products in the DeFi space.
However, these structured products introduced by Yearn Finance come with their own set of risks, particularly in their response to liquidity events. The complexity of these products, especially when leveraging is involved, makes them highly sensitive to sudden changes in market conditions. The greater the leverage used in these strategies, the more significant the risk.
Considering these concerns, Tortle Ninja presents an advanced solution in DeFi management through its unique conditional layer known as Combo Triggers, or simply Triggers.
Triggers are our most significant innovation to date. They enable the evolution of a strategy by utilizing both on-chain and off-chain information.
Triggers allow a strategy to adapt over time, interacting with various protocols. For example, they can execute actions such as selling an asset at a specific price, preventing liquidation in a leveraged position, or adjusting collateral based on oracle data. Additionally, we can seamlessly integrate with any service to develop new logical frameworks.
Triggers complement structured products exceptionally well because they help these products evolve and adjust to changing market conditions.
With our analytics engine, you’ll receive real-time data on profit and loss (PnL) and annual percentage yield (APY) at a detailed level, regardless of the particular product you’ve invested in.
Tortle Ninja guarantees you have access to precise information concerning your investment’s actual value and performance, along with the capability to automate actions in response to specific conditions.
About Tortle Ninja
Tortle Ninja offers users an advanced DeFi algo-trading experience, allowing them to execute spot and derivatives strategies with ease, measure their effectiveness using real-time data, and adapt swiftly to ever-changing market conditions.