Providing liquidity in an AMM is one of the best ways to earn yield on crypto assets. It’s also one of the easiest ways to lose your mind. At first, it seems like a perfectly good idea. Add your cryptos to a liquidity pool and get rewarded with trading fees. Apart from the initial transaction to add the assets to the pool, there is nothing else to do. No need to keep track of market prices, no placing or cancelling of orders, nothing. The smart contract does it all for you… at least that’s the theory.

There is a major catch unfortunately — impermanent loss. As traders buy and sell the underlying assets, the composition of the pool changes. If one of the assets gets sold more than bought, then the pool’s balance of that asset grows, whereas the other, more valuable asset gets drained from its reserves. You end up owning more of the asset that’s declined in price and less of the one that’s appreciated. Impermanent loss is the measure that quantifies this effect. It compares the value of the assets in the pool to the value of the assets had they been held outside the pool.

Let’s illustrate this with a concrete example. (Skip this bit if numbers do your head in.) Assume you have 1000 USDC and $1000 worth of ETH. Let’s say the price per ETH is $4000, so that you hold 0.25 ETH. You add these assets to the Uniswap ETH/USDC pool in a ±50% range around the current pool price. After some time has passed, you come back to check how you’re doing. The market price has fallen to $3000 per ETH, and there is less USDC and more ETH in the pool. To be precise, you will find that you now have 270 USDC and 0.46 ETH. This means that your portfolio, which initially was worth $2000, is now worth $1652. Ouch! But hold on, is this actually a problem? After all, your initial portfolio, had you not committed it to the pool, would have been worth less anyway because the price of ETH has fallen. If you do the maths, you’ll find that had you hodled your initial portfolio outside the pool, it would now be worth $1750. Your impermanent loss is $98, or 5.6%.

The frustrating thing about impermanent loss is that it’s always a loss. No matter whether the price goes up or down, and no matter by how much. The only exception is when the price returns to its initial level. At that point the assets in the pool are in the same proportions again as in the initial portfolio, and the impermanent loss is zero.

If you are now thinking to yourself that calling the loss ‘impermanent’ because of this one special case must be a bad joke, then that’s an understatement. It’s mockery. Your loss becomes permanent if the price never returns to its initial value or you withdraw your assets before it does.

So why would anyone provide liquidity, if almost certainly they end up with an impermanent loss? Traders get charged a small fee for each swap that they execute, which is passed on to LPs. This cash flow from trading fees constitutes a yield that LPs earn. But don’t be fooled by high headline APYs that many platforms advertise. Liquidity provision is only profitable if trading fees earned exceed the IL incurred. Whether or not this is the case depends on trading activity and market price movement. You don’t know either in advance, but you can get a feeling for what the economics are by looking at what happened historically, for example in the past week, month or year. A more advanced approach would be to build a quantitative model that describes the price process of the underlying asset pair and the expected trading activity, and form an opinion based on this.

Liquidity provision is only profitable if trading fees earned exceed the impermanent loss incurred

In Uniswap V2, everyone was on a level playing field. All you could do was pick a pool. In V3, you have to choose a price range over which to provide liquidity. By concentrating your liquidity around the current market price, you earn more trading fees per unit of liquidity, all else being equal. Great, you might think, a higher return on my capital. But guess what, you aren’t the only one trying to juice your returns. All liquidity providers aim to maximise the amount of fees they earn, so you can only increase your share of the trading fee pie if you provide liquidity in a narrower price range than others. However, as you tighten the range, your IL risk grows bigger. Providing liquidity becomes a competitive game in which professional market makers that crunch data in real-time and have 24/7 operational capabilities have the upper hand.

Is this the end of the road for the average hodler who was hoping to earn a yield on their cryptos as an LP? Fortunately not. We’ve done the heavy lifting that professional LPs would do, such as understanding the dynamics of AMMs like Uniswap, building and calibrating models, backtesting based on historical data, and so on. But instead of keeping the results to ourselves and running a secretive market making operation, we will open source it all and write a suite of smart contracts that is free to use for anyone. All you’ll need to do is deposit your assets with Akiu, and they will automatically be deployed on Uniswap and rebalanced in such a way that positions stay in-range, and provide protection against impermanent loss. As a result, you can remove your liquidity at any time without nasty surprises — with Akiu, APYs are WYSIWYG.