Bancor’s Approach to Handling Impermanent Loss Shows Financial Viability
Bancor has been working on a reliable method to address impermanent loss and it seems to have struck gold with its insurance-based approach
The Bancor Network has been busy trying to solve the issue of impermanent loss on its decentralized exchange. In a recent report, the protocol showed significant success with its approach, leading to the belief that it might be able to handle the protection of temporary loss of funds in the long term.
Impermanent Loss on DEXs
Yesterday, Bancor released a Protocol Health Report for its v2.1 decentralized exchange (DEX) upgrade.
The report covered the exchange’s financial and operational performance for the past quarter, showing significant liquidity and revenue gains.
As the report showed, liquidity across the DEX rose by 100 percent over the past three months, resulting in about 700,000 BNT (worth $1.12 million) in earnings from swap fees. However, the platform’s strategy on impermanent loss appeared to have faltered.
When Bancor launched the DEX late last year, it focused primarily on effective impermanent loss management.
Also known as divergence loss, the impermanent loss is a problem that affects mostly exchanges that run on the automated market maker (AMM) protocol. It occurs when liquidity providers (LPs) lose funds due to the volatility of a trading pair. It basically describes how much revenue an investor would have earned if they had held on rather than provide liquidity to the market.
The effect of this divergence is a loss of value, compared to the benchmark “buy and hold” portfolio.
The loss is termed “impermanent” because it could be reverted if the prices returned to their original state. However, even in the best scenarios, losses due to divergence will reduce liquidity providers’ profits from price swings.
Possible Long-Term Benefits
Bancor had initially tried to solve the problem with oracles, which reads token prices and render arbitrage virtually unnecessary.
However, front-running issues rendered this approach impractical. So, the exchange deployed an insurance mechanism to cover the cost of impermanent loss.
The project implemented a vesting schedule to incentivize LPs to stake their tokens in the long term.
The protocol's strategy was to incentivize more altcoin holders to become LPs instead of adopting the buy-and-hold strategy. Another strategy Bancor plans to explore is to encourage projects to use their treasuries to provide liquidity to AMMs. Just like proof-of-stake (PoS) rewards, the method could allow projects with considerable token reserves to increase liquidity on token pairs and also get additional rewards.
The vesting schedule will see Bancor provide one percent coverage on liquidity capital for up to 100 days. However, LPs who make withdrawals before 30 days won’t get any compensation for losses in that period.
Bancor’s approach appears to be yielding benefits. As the company reported, the total impermanent loss associated with withdrawn liquidity amounted to 41,000 BNT ($64,000). On the flip side, the protocol also earned 350,00 BNT ($560,000) in fees.
Bancor added that some LPs withdrew their deposits before getting 100 percent insurance. These LPs got partial protection, which was paid based on their coverage level. The report pointed out,
“As the proportion of insurance policies with 100% protection increases over time, it stands to reason that the associated cost to the protocol will rise. However, various factors suggest the protocol is able to handle this insurance burden.”