However, there is no such thing as a free lunch.
Bancor is updating its protocol once again to overcome the insidious problem of impermanent loss, which it previously called „DeFi’s dirty little secret“.
Impermanent loss, also called divergence loss, affects exchanges based on automated market makers such as Bancor or Uniswap. It occurs when the prices of two assets in a liquidity pool diverge significantly, with one side rising or falling sharply in value.
The effect is a loss in value compared with a benchmark „buy and hold“ portfolio. Liquidity providers (LSPs) may make less money than they would have if they only had the tokens separately, even though they earn commercial rates from the protocols.
The next Bancor upgrade will solve the “Little Secret of DeFi“.
The problem is due to arbitrage traders, who are necessary for MMAs to bring their prices in line with those of other markets. However, their activity extracts value from the LPs that facilitate the exchange.
The loss was initially called „impermanent“ because if prices return to their initial state, the loss is reversed. However, even in the optimistic scenario, divergence losses reduce the additional gains that LPs would otherwise have made from price changes.
Bancor has made the elimination of the non-permanent loss Bitcoin Trader one of the key features of its second version. Its initial approach was based on oracles, which would read the actual prices of each token and make arbitrage largely unnecessary.
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However, Nate Hindman, Bancor’s growth director, told Cointelegraph that this approach was finally revealed to be too risky. Oracles are slow to update and can be exploited by fast traders, he argued.
There has also been a growing realization in the industry that temporary loss is impossible to truly solve. Each solution has certain drawbacks or simply shifts the loss to someone else.
The latter approach is what Bancor is seeking with V2.1. It is introducing the concept of temporary loss insurance, which ensures that liquidity providers will receive up to 100% of their initial capital, plus accumulated commissions. The exact percentage is subject to an allocation schedule based on how long the user is providing liquidity, Hindman explained. Full coverage is reached after 100 days, but there is an initial 30-day window during which no payments will be made.
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The insurance claim itself is paid indirectly by the protocol and BNT holders by issuing new tokens on request, if necessary. The pools covered by this insurance and the exact vesting parameters are decided by the EU governance. The solution is somewhat similar to the way protocols such as Uniswap are currently subsidising some liquidity providers with new UNI tokens.
But in the case of Bancor, there is also a deflationary mechanism. Since all groups have NTBs as a second token, the protocol can offer liquidity provision from a single token; it simply coins the corresponding amount of NTBs required. The protocol then receives fees as a co-investor in the pool. When someone decides to supply only NTBs, the previously coined supply and accumulated tariffs are burned, resulting in a net supply restriction.
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The expectation is that, with sufficient use and in periods of low volatility, tariff deflation will prevail and accumulate value for token holders.
„We consider this to be a liquidity squeeze 2.0: instead of paying LP arbitrarily to provide liquidity in our protocol, we are compensating for the individual impermanent loss incurred“.
As it is increasingly clear that loss from divergence is inevitable, future solutions may offer a spectrum of ways to spread risk across different market participants. Mooniswap, the DEX launched by the 1inch exchange team, works on a similar principle by limiting the profits that can be made by arbitrage traders.