Contents
Disclaimer
Key Risks to you as a Liquidity Provider
Divergence Loss (Impermanent Loss)
Ensure you are familiar with your risks
Before deciding to become a liquidity provider (LP) in a Liquidity Book Automated Market Maker (AMM), you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and, therefore, you should not invest money that you cannot afford to lose. It is essential to be aware of all the risks associated with liquidity provision in decentralized finance (DeFi) and seek advice from an independent financial advisor if you have any doubts.
The key risks you should consider
Impermanent Loss: When the price of your deposited assets changes compared to when you deposited them, there can be a temporary loss in value known as impermanent loss. The final outcome of your investment could be less than your initial deposit if you decide to withdraw your funds.
Smart Contract Risks: The protocols are based on smart contracts that are immutable once deployed. While they are often audited and tested, there is no absolute guarantee that they are free from vulnerabilities or bugs. This can pose a risk of funds being lost due to exploited vulnerabilities.
Systemic Risks: The DeFi ecosystem is interconnected, and failures or issues within one protocol can have cascading effects throughout the system.
Liquidity Risks: There may be times when it is difficult to exit your position due to insufficient liquidity in the market, which could lead to losses, especially if you are trying to exit during a market downturn.
Regulatory Risks: The regulatory environment for DeFi is still evolving. Changes in laws or regulations can unexpectedly affect the legality and mechanics of DeFi protocols and could potentially cause loss or closure of the platform.
Market Risks: The highly volatile nature of cryptocurrency markets can lead to wide fluctuations in the value of assets provided as liquidity. These market conditions can significantly affect the profitability of liquidity provision.
Operational Risks: Errors or failures in the execution of transactions can occur, leading to potential losses.
By becoming a Liquidity Provider using Liquidity Book, you affirm that you understand and accept these risks, and you agree that the protocol, its developers, or other LPs are not liable for any losses you may incur.
Divergence Loss (Impermanent Loss)
Concentrated liquidity allows users to capture more fees with significantly less liquidity. The trade-off is the added risk of divergence between the assets in a Liquidity Pool.
Examples:
Token A: $100
Token B: $1
Alice provides $1000 in liquidity, as 5 A + 500 B, at price 99.9 - 100.1 range.
Scenario 1: Token A increases to $200, Token B stays at $1
| Token A | Token B | Value | Imp. Loss |
Holding | 5 | 500 | $1500 |
|
Joe V1 | 3.54 | 707.11 | $1414.21 | 5.7% |
Liquidity Book | 0 | 1000 | $1000 | 33.3% |
Scenario 2: A drops to $50, B stays at $1
| Token A | Token B | Value | Imp. Loss |
Holding | 5 | 500 | $750 |
|
Joe V1 | 7.07 | 353.55 | $707.11 | 5.7% |
Liquidity Book | 10 | 0 | $500 | 33.3% |
The above scenarios highlight the differing factors of divergence loss and how they can be magnified when using Liquidity Book (Concentrated Liquidity) versus simply holding or executing a 50/50 strategy on Joe V1.
Managing concentrated liquidity involves significant risk and is not suitable for all DeFi participants. The nature of concentrated liquidity positions can lead to increased exposure to market volatility, impermanent loss, and other financial risks. This activity should only be undertaken by those who have a comprehensive understanding of decentralized finance (DeFi) protocols and are prepared to accept the possibility of substantial losses, including the potential loss of all invested capital. The information provided here does not constitute investment advice, financial advice, trading advice, or any other sort of advice and should not be treated as such.
If you would like to further understand your risks please join the LFJ Discord and speak to one of our community managers: Link to Discord