💧Liquidity & impermanent loss management
Smart liquidity and impermanent loss management
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The challenges of CLMMs (v3 AMM) 🦄
Also known as "v3 AMMs", Concentrated Liquidity Market Makers (CLMMs) allow liquidity providers to concentrate their liquidity within a price range in order to increase the efficiency of their capital for the benefit of swapers. A liquidity band represents the price range over which a liquidity provider agrees to facilitate transactions. This game-changing innovation allows traders to trade with virtually zero spread slippage and very low fees. This DeFi exchange mechanism quickly becomes more efficient than any other solution, even competiting the efficiency of centralized order books... Here is an illustration of the difference between an AMM v2 and a CLMM:
However, with this efficiency comes great complexity for users. They now have to choose the best price range in which to provide their liquidity. These improvements are rapidly becoming inaccessible to retail investors, as the provision of liquidity becomes increasingly professional. DeFi investors are gradually turning to solutions such as Lobster, which calculates the right liquidity ranges using institutional algorithms that are now accessible to everyone.
How does Lobster calculate the liquidity range to mitigate impermanent losses? 🩸
First of all, we need to understand how impermanent losses occur in a traditional liquidity pool without active management.
Basically, the liquidity pool holds a correlation ratio between the two assets, otherwise known as the relative price change. This relative price is likely to change, for example when a token is rising in value. When a token price rises, there is higher demand among traders. This will trigger more trades therefore a smaller quantity of the rising token in the pool, and by correlation, on your position.
Here is an impermanent loss curve for a full range liquidity provision :
However, when we can actively manage the liquidity range, we can limitate the impact of impermanent loss. By concentrating liquidity to a greater or lesser extent, it is possible to recover the impermanent loss even if the correlation ratio between the two tokens does not return to the same level as before the loss was incurred. Lobster has mathematically succeeded in making the impermanent loss our ally despite the evolution of stock market prices. Here's how:
Let's consider a certain volatility (1) in the price of the two assets in a pool, so that the liquidity provider is always exposed to the worst-performing token. To compensate for this impermanent loss, the same inverse volatility is normally required to recover the initial relative price of a pool. In reality, by actively concentrating or deconcentrating a concentrated LP position (2), it is possible to recover most of the impermanent loss without needing the same inverse volatility. All we have to do is anticipate the volumes of trading liquidity thanks to the only variable we can change over time: liquidity concentration.
For example, if the relative price changes on the pool and goes to +10% and we concentrate the position 5x more, we recover the impermanent loss only with a -2% relative price change volatility, and not -10%. If you now manage your concentration intelligently, you can almost always recover your impermanent loss even if the relative price change of the pool follows an upward or downward trend. That's what Lobster does, and what no one else does.
Here's what your liquidity range looks like over time with this type of strategy:
In blue the relative price change
In gray, the upper and lower limits of the chosen liquidity ranges
