Inconsistent losses in DeFi

Anyone who contacted decentralized finance, or rather, provided his or her assets for various pools, faced the concept of an inconsistent loss. In short, this is a situation when the price of an asset at the time of withdrawal is lower than at the time of placement. Moreover, this is not some unique scenario, but a variant of a typical development of events. So why do users continue to work with liquidity pools? Because everything is not so simple here.

Now many DeFi applications are experiencing explosive growth. For example, we are talking about projects such as Uniswap, SushiSwap or PancakeSwap. With their help, anyone who has funds can become a market maker and earn on commissions by donating their assets to a common exchange pool. This does not require any specific knowledge, or special equipment, or even large sums of money. However, this is an advantageous process and some disadvantages. One of them is intermittent losses.

What are volatile losses?

Imagine you have contributed a certain amount to the pool. As a rule, in two assets from a currency pair, to ensure their normal exchange at market rates for other users of the service. Nevertheless, if the absolute price of one of the assets or their value relative to each other changes, then you can withdraw a smaller amount than you originally invested.

Let's look at an example. There is a certain Bill who found out that with the help of DeFi you could organize a stable passive income for yourself. Therefore, he chose a certain, reliable and active service for himself, and then he contributed a certain amount to his pool. Let's say - 1 ETH and 100 DAI. Why exactly this? And because in many automated market makers, only pairs of tokens for equivalent amounts can be deposited. Since the DAI is pegged to the dollar, we can say that Bill contributed $ 200 worth of assets to the liquidity pool. Contributed and now counts on profit from the commission.

But not so fast. Let's say there are a dozen more participants in the pool who contributed the same amounts, so now there are 10 ETH, 1000 DAI, and the total liquidity is 10,000. So Bill now owns 10 percent of the entire pool. And, accordingly, 10 percent of each commission.

Let's imagine that the relative price has changed due to some external events, and now one ETH is equal to 400 DAI. Now, arbitrage traders will add and subtract ETH to the general pool so that their ratio starts to reflect the current price. At the same time, the overall level of liquidity - 10 thousand - remains constant. As a result, we now have 5 ETH and 2000 DAI in the pool.

For whatever reason, Bill decides to withdraw his funds. As we recall, he is entitled to 10 percent of the pool, so he withdraws 0.5 ETH and 200 DAI, which is equivalent to $ 400. Put 200, brought 400 - cool? On the one hand, yes. On the other hand, if I hadn't put it at all, I would have kept 1 ETH and 100 DAI for $ 500. This is inconsistent loss. In this situation Bill got off with just a lost profit, but things may turn out in such a way that the withdrawal will turn out to be less than originally placed. Moreover, any change in both absolute and relative prices will lead to similar losses. In this case, only the price ratio and the time of the deposit matter.

Why do users keep depositing funds?

As you know, fluctuations in cryptocurrency markets are not always well predictable, and the currencies themselves are highly volatile. Yes, in the case of some stablecoins (the same DAI), it is less, but still some unpredictability remains.

Do not forget the profit due to the percentage of the commission. In the same Uniswap, for example, the commission is 0.3 percent of the transaction amount. So our Bill consistently receives 0.03 percent of all transactions carried out under the protocol he has chosen. So the larger the trading volume, the higher its profit. And this very often compensates a possible losses.

In addition, the very term "inconsistent loss" characterizes the "temporary" of this phenomenon. It becomes constant only at the moment of withdrawal of money, and before that your assets will continue to make a profit due to the commission. In addition, the price ratio may return to its previous value, which will also lead to the disappearance of losses. You just have to wait.

Therefore, it is extremely important to initially choose such DeFi pools in which the risk of such losses is minimal. This applies to large projects with low volatility. But they, as a rule, bring less profit. The same Bill with his 1ETH / 100DAI will be able to count on hundredths, or rather thousandths or even less of a share of the total commission.

So either you are making minimal "passive income" or you are preparing to face significant "inconsistent loss" on less stable but more profitable resources. In the second case, it is better to start with a "personal check" and depositing small amounts that you are not afraid to lose. But this will give you a rough idea of how things are going with the commission, and with the volatility, and with the trading volumes, and with other important indicators.

In any case, it is impossible to completely exclude inconsistent losses - they are directly related to the peculiarities of the work of automatic market makers. But it is possible to ensure that the profit from the commission will outweigh these losses.