A new study by Bancor, a decentralized trading protocol, has shown that more than 50% of Uniswap liquidity providers are losing money due to a phenomenon known as impermanent loss (IL). The study’s publication has been accompanied by the release of a tool that allows decentralized finance (defi) users to check how much they’ve lost due to IL.
Uniswap is the world’s most popular decentralized exchange (DEX). Every month, more than $70 billion in trading volume is executed on the Ethereum-based exchange. However, users who provide liquidity in the expectation of earning fee rewards may not be raking in the profits they anticipated. (See Insiders’ Hot Stocks on TipRanks)
Uniswap Users to Battle Impermanent Loss
Uniswap v3, the latest and most sophisticated version of the popular decentralized exchange, is relied upon by tens of thousands of crypto traders. While some use the automated market maker (AMM) to swap between tokens, e.g. ETH to USDT, others provide liquidity by allocating tokens to a pool of assets controlled by a smart contract.
Every time a trade is executed on Uniswap, liquidity providers (LPs) earn fees proportional to the amount of liquidity they have supplied. This fee is usually set at 0.3% but can be as low as 0.05% for stable assets, and as high as 1% for more exotic pairs.
Over time, these fees can generate significant profit for LPs – theoretically, at least. In practice, however, the revenue generated in the form of fees is often exceeded by dollar losses caused by what’s known as impermanent loss (IL).
Without getting too technical, IL is the result of fluctuations in the underlying value of the assets being swapped. Crypto assets can be volatile and when a token drops in price, it leaves liquidity providers with less, in dollar terms, than they started out with. The extent to which impermanent loss can erode profits has been shown by the new study.
“Our core finding is that overall, and for almost all analyzed pools, impermanent loss surpasses the fees earned during this period,” its authors conclude. “We have collected evidence that suggests both inexperienced retail users and sophisticated professionals struggle to turn a profit under this model.”
Liquidity Providing Is Complicated
The previous version of Uniswap, known as v2, enabled users to add a 50-50 weighting of tokens (e.g. $1,000 of ETH and $1,000 of USDT) in a few clicks. While Uniswap v2 is still available, accounting for around on-third of v3’s monthly volume, it’s been superseded by the more complex Uniswap v3.
Despite having more bells and whistles, however – including the ability to provide liquidity in tightly controlled price ranges – v3 has failed to protect LPs from impermanent loss. In fact, the complexity of v3 may be compounding the problem.
Despite Uniswap v3 generating more fees than any other defi protocol, more than 80% of the pools analyzed in the study saw LPs lose out due to impermanent loss.
Moreover, the study found no statistical evidence that users who adjusted their positions more frequently performed better than those who didn’t, suggesting that v3’s dynamic fee settings may actually be worse for LPs than those of the static v2.
DEX Designers Grapple with Impermanent Loss
The architects of DEXs such as Uniswap have long wrestled with the problem of how to incentivize liquidity provision with users being penalized through IL.
Tellingly, the study into Uniswap impermanent loss was commissioned by Bancor, the developers of an alternative AMM that promises “100% protection from impermanent loss” by allowing users to supply single-sided liquidity. Instead of pooling two tokens in equal measure, in other words, it allows them to supply just one, such as a stablecoin whose price will scarcely fluctuate.
While solutions such as Bancor provide LPs with greater protection, the bulk of all DEX volume remains centered around Uniswap. For all its faults, it’s still the industry’s biggest AMM.
Greater awareness of Uniswap’s impermanent loss problem probably won’t spark a mass exodus of liquidity. However, it will at least make LPs more aware of the risks of supplying liquidity in the pursuit of rewards.
Disclosure: At the time of publication, Reuben Jackson did not have a position in any of the securities mentioned in this article.
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