Impermanent Loss Thoughts

Why can’t a Liquidity pool be subsidized by a coin to deal with impermanent loss? If the price of the coins raises or falls by any percentage, you’re looking at some sort of impermanent loss that is hopefully covered by the transaction fees. However, when the interest in coin A goes up and the price climbs and B falls (both rise or fall and vice versa) wouldn’t it be beneficial to have a fourth coin? wXTZ, XTZ Liquidity Token and an exchange token that is minted and publicly traded (Like Uni). The percentage change could be tracked from the initial deposit and the difference could be subsidized by the fourth coin. If the exchange token is worth $.50 cents and the initial investment were $10 at a 1.5% increase, you’re looking at a 2% loss. $2 would be paid as an exchange token as well as the trading fees. If the tokens are spent back into the exchange to swap for XTZ the tokens would be burned further increasing the price. I feel like the fourth token approach might be the solution to the impermanent loss problem but I’ve been reading entirely too much literature on Tezos today and it’s all starting to mush together.

I’d really love feedback on what the agora community thinks about this, or any other ideas you might have floating around so that collectively we can find a solid answer. I’ve probably over simplified it but collectively I feel like we can find a solution. Thanks in advance.

Why can’t a Liquidity pool be subsidized by a coin

Why does that coin have value?

I think there are a couple ways.

If the token has utility. It the token is usable across exchanges and wallets. A standard FA 1.2 or 2 token that could be used across wallets and Defi platforms like Dexter and Quipuswap and exchanges like binance (should be an easy list) and coinbase, that could be exchanged across those platforms for different offerings or sold directly to the market for fiat value.

Scarcity. The price of said coin would directly reflect a limited minting supply whether is be finite or infinite but restricted to a certain quantity during a given time frame. This brings speculation to how often the token will be used, how much it’s worth, and how many tokens might be burned when directly exchanged on a Tezos exchange like Quipu or Dexter.

Speculation. A standard token used across the exchanges in the Tezos Ecosystem will only become more useful as the technology grows.

Fungible, Non-consumable, portability, Durable, Highly Divisible, secure, easily transactable, scarce, sovereign, decentralized, and programmable. Are the basic traits for a currency and I think that is easily reached with any new token created for this purpose. All that is truly needed is a listing where the Token could be exchanged for Fiat. Then, you have created a standard of measurement.

What utility does it have?

Why would it be used at all?

Tez already has all these characteristics.

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But, Arthur, clearly there are a bunch of governance tokens that were successfully airdropped to CFMM liquidity providers on Ethereum, and, clearly, they led to liquidity being provided, and, clearly, people are ascribing some value to them, so what gives?

A few of things are going on.

First, there is simply confusion. If enough people believe that a dex governance token has some value from the mere fact that it sits next to a useful smart-contract, then that can be enough to sustain its value, at least for a while. This gets diluted away as more and more smart-contracts are launched with some tokens sitting next to them. The more generous take on this is that people value having an original Picassos in their living room far more than they value having an indistinguishable copy and who’s to say they are wrong?

Second, some people might cynically believe that these dex governance tokens aren’t really worth anything but figure they can sell them to people who fall in the first category, or even to other people like them who figure they can do so later when there are even more people in the first category. This is basically a gambling game of hot potato, with players knowing full well they are playing hot potato.

Now, you can very well subsidize liquidity provision by catering to (1) and (2) but it seems a bit icky doesn’t it?

Third, there is speculation that some governance tokens will eventually capture cash flows associated with the use of the underlying smart-contract. For example, the UNI token could at one point in the future be programmed to capture 0.05% of the transaction flow through Uniswap.

The third reason is by far the most plausible one for ascribing value to these and it doesn’t share the ickiness of 1 and 2. It’s not, however, without its own problems. Let me put it as dialogue because there are a series of arguments and counter-arguments to consider.

— “The token is valuable because it captures part of the economic value provided by the smart-contract in the form of fees.”
— “It’s easy to replicate the contract, it’s open-source! A version of it without the fee is more appealing.”
— “Not so! The original will have much greater liquidity making it much more appealing even with the fee.”
— “The competitor can automatically route orders to the cheapest pool available, negating the network effects from liquidity.”
— “Yes, but doing so will involve extra complexity and extra gas fees. It might also not work at all on a layer 2 chain where CFMM might move.”
— “You still have the option of raising cold, hard, cash, using that to bootstrap liquidity, and undercut the fee.”
— “It’s not just about the liquidity, it’s integration in wallets, user experience, brand reputation. There’s an entire set of intangibles that are hard to replicate and 0.05% if a very small amount to pay for the convenience. Dropbox is a successful company offering commodity technology in a tidy package.”
— “Fees in traditional finance on centralized exchanges are microscopic in comparison. The financial industry squeezes pennies out of every trade. Choosing which cloud drive provider to pick is very low stakes in comparison. People care about the absolute cost not just the percentage take. Besides, comparison with companies is overrated. Companies place moats to prevent losing network effects from interoperability, moats that can’t really exist in an open environment.”

Now suppose that you’re convinced by the argument that

  1. A successful enough dex can be sufficiently well protected from the competition to sustain fee extraction.
  2. The right to receive those fees can be tokenized
  3. Those tokens can be used to bootstrap the success of the dex in the first place

First of all, this does not mean that the governance token can magically cancel out impermanent loss. The only thing it does here is, at best, shift some of the fees received by late liquidity providers to early liquidity providers. There is a reasonable case that impermanent loss is greater in the early days. When there’s little liquidity, much of the volume is arbitrage, not people wanting to use the contract out of convenience. Nonetheless, it doesn’t eliminate impermanent loss in the long run, at best it lets you get over an initial hump.

Ok, but let’s admit we buy the argument that tokens can capture part of the economic activity in the long run. Then this really becomes an argument for “nationalizing” the functionality at the protocol level and burning 0.05% in tez and using on-chain DAOs to bootstrap those contracts.

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Firstly, thank you for the well thought out response. This helps a lot when it comes to actually finding a solution.

Utility - I think the utility would have been from the fact that an FA token could be moved between Exchange A to Exchange B for the purchase of different offerings. For instance, Coinbase offers 50 tokens and Binance offers 150. If the token were available on two platforms that offered even 1 difference in offering, you’ve found some utility. In truth, everything on Tezos has some form of utility, we just have to find a way to use it. Perhaps the exchange token could be used to “gamble” similarly to the Stake pool price estimation game. It doesn’t have to be anything too grandiose, just something to add value to a coin. I guess you could argue that it would be best to simply create a duplicate of Tezos with a finite supply and no voting power. A Tez has a ton of utility, more than any other coin. However, until the next proposal, only 1,000 will be made. They never upgrade, the protocol never changes, and there is not voting requirements. You’ve basically created a highly functioning bitcoin. I simple store of value in which a limited supply are minted over a long period of time. By the time all the coins are minted, you would have a solution to impermanent loss by some other means. (Hopefully)

When it comes to having value for a governance token, I think a lot of people find convenience the value. If you have .000000043 BTC and .00034 Eth .023 XTZ, you can simply convert those coins to Binance coin to make them spendable. Possibly do the same thing with a governance token? Allow exchanges to basically create a melting pot for all the miniscule amounts and turn them into something usable. This will get very helpful as more FA tokens are released. People may not even like the Picasso in their living room, they like telling others they have a Picasso in their living room. The same can be said for designer handbags. Often they offer less utility, less comfort, and cost 100 times as much. But the vanity of having what others don’t becomes the measurement of value.

When It comes to the second option, it of course seems icky but we are empowering people to become their own banks. What they choose to do with their money is entirely up to them. If they receive the exchange token and turn it into Tez, great! If they choose to gamble that if they hold the price will rise, it may work out, it may not but I think it plays a part in utility. It certainly adds excitement.

When it comes to the third, I will humbly admit that I am out of my league (at this point, but ill continue to research) with some of the references you’re making and how to solve them. I think my first suggestion might cover some of the arguments. Creating a store of value coin that people are rewarded for providing liquidity is a pretty solid way to say thank you to those who are improving the Ecosystem.

Again, I really appreciate the response, Arthur. I’d love to hear from other members as well. The topic is being seen a lot but not too much feedback is happening. I’m not the smartest individual so I’m always looking for help and insight. Thanks in advance!

Curve, on Ethereum, currently grants cash flow to stakers. The concept of a governance token having value is beyond the hypothetical stage, it’s live now.

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Sure and so does the maker token. Whether much of that rent is defensible in the medium to long run is a whole other story.

In January alone SushiSwap paid xSUSHI stakers $6.1 million (Messari report)
It’s impressive for a 6 month old fork of Uniswap

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Wow, that’s impressive. I think most users (LP’s and end users) feel more comfortable using an exchange that is decentralized and community governed- and it doesn’t hurt when the governance tokens pay a dividend like that!

Can you elaborate briefly on how it might not be useful as time goes on? I remember you saying something about parachains making themselves obsolete in an interview but would love some more information on that as well, if you have time.