How Our APM (Not AMM) Helps Avoid Impermanent Loss in DeFi
As the crypto space moves forward, with new ideas emerging for new approaches to existential problems, one of the topics in contention lately is the need for better Automated Market Makers (or AMMs).
These protocols that allow traders to automatically exchange one crypto asset for another on a blockchain are important for the crucial role they play in the decentralised finance (DeFi) ecosystem. They enable the execution of trades in a permissionless way — -which was new at first. They achieve this by making it possible to create traditional order books on-chain using liquidity pools rather than having the usual market of buyers and sellers as it is the case with centralised cryptocurrency exchanges.
In other words, AMM protocols could be identified to have been pivotal in the shift to decentralised exchanges. These peer-to-peer marketplaces use AMMs to automatically facilitate crypto asset trading orders. AMMs came along as innovative as they made the process of trading these assets without any intermediaries possible. Like a computer programme, they automate the working together of liquidity providers (LPs) and liquidity takers in the trading process.
Then their main point of weakness emerged: impermanent loss (IL).
How impermanent loss (IL) happens
IL is the loss that liquidity providers incur even when they don’t actually have to lose money. It happens when the relative price of two crypto assets on different exchanges diverges substantially from that implied by the bonding curve. Remember, LPs invest in liquidity pools to earn passive income by sharing in the available yield interests. They do so by using the existing AMM system that requires two tokens as a pair for them to be able to provide liquidity.
When the prices of the assets in the pool change according to market trends, it becomes a risk to the LP.
That is, in the case of a liquidity pool where an LP is offering a pair and it happens that there is an increase in the value of one of the assets, it gives liquidity takers the incentive to withdraw the crypto asset whose value has risen. Or, depending on the market situation, it could be that the price of one of the assets dropped below the investment rate. IL will occur in either of the two instances as the LP’s supposed interest that is meant to accrue from providing liquidity gets wiped away due to the price action. In some cases, it even affects the LP’s principal as well.
This all forms a part of why the D/Bond CEO, Yu Liu, thinks DeFi has been quite inefficient from the start, particularly for its yield farming system. He suggests in this interview that the issue of IL and the like, are a byproduct of the incompetence of the financial services on the blockchain. As a result, Liu believes retail investors in DeFi have been in an existential disadvantageous situation, and would remain so for as long as they continue to be exposed to the same DeFi products with the same rules, and same rewards as big investors. It is why the market is usually — and will continue to be —volatile, he maintains.
“When the market is not doing well, the big investors have the first information,” Liu said. “They will leave the market before everyone else. They will pull out all their tokens and it’s the retail investors that will suffer most of the loss. That’s basically why the system is so volatile and why it’s not friendly to retail investors.”
It begs the need to build a more stable system, he added, noting that one of the ways to do that is to replace the existing AMM system with the Automated Pair Maker (APM).
D/Bond’s proposition: The APM
Based on the existing AMM system, IL is inevitable for LPs as a unique risk involved with providing liquidity to dual-asset pools in DeFi protocols. The reverse is the case with the APM that we propose. It works based on a contract hence its efficiency over the existing system. Unlike the current AMM system, the APM only needs one token which retail investors would provide to mint D/Bond’s token. With this, investors would not have to sell their tokens to buy D/Bond’s. Yet, it ensures that the price of any given token is not directly correlated to the token reserve held by the pool. They will also follow a fixed rate and predetermined schedule agreement as it is with the existing system.
Another upgrade with the APM is that interest yields from the pool will be expressed in the form of bonds. The bonds would be used to redeem the interest along with the principal — like a national bond — based on the interest rate opted for. After choosing a risk profile in accordance to the interest rate and receiving the bonds in their wallet, investors can choose to wait for the agreed period of maturity. It is also possible to sell them before the maturity date — in case of an urgent need —on D/Bond’s (decentralised) secondary market. This adds to the dynamics of D/Bond’s new approach to DeFi as it was practically impossible with the current system for LP tokens which represent the collateral in a pool to be tradeable until maturity. This is because their tokens’ data structure is incapable of handling such by design. That is where our new token standard, ERC-3475, with its abstract storage capabilities comes to play. With the standard, an LP token is made tradeable and its value guaranteed on our secondary market.
Based on the existing system, retail investors will always be at a disadvantage against institutional investors which is not good. “So, in order to prevent it, the best way is to first build a pool with all kinds of collateral and then use this pool to create some kind of bond,” Liu said in the interview as he explains the concept driving D/Bond’s efficiency for DeFi. “So the bond represents the percentage you own in this pool. You can have a tiered ranking system for the bond.”
D/Bond has helped create a system where a pool could be separated in two to cater to both retail and institutional investors as well as their respective risk appetite. This is a new form of balance in DeFi. Stay with us!