Aluno: Ruben Dos Reis Mendes
Resumo
Abstract
Within the realm of decentralized finance, liquidity providers are esteemed for
their vital role in maintaining liquidity pools. Nevertheless, they are exposed to a
significant risk referred to as impermanent loss. This happens when the prices of
one or more tokens fluctuate in relation to others or others within the same liquidity
pool, ultimately reducing the initial quantity of one or more assets and leading to
a temporary loss for the liquidity provider.
Impermanent loss can be affected by several factors, including price volatility,
asset correlation, trading volume, fees earned, time, and pool size. To reduce the
impact of impermanent loss in different market conditions, it is important to have a
good understanding of these factors and to choose the appropriate liquidity provision
strategies. By doing so, one can minimize the negative effects of impermanent loss.
To make informed investment decisions, liquidity providers must consider impermanent loss and carefully choose the most advantageous DeFi protocol to provide liquidity. This enables effective investment management and helps determine
whether to enter or exit a specific pool.
This research provides a risk assessment that offers liquidity providers guidelines to evaluate which of the four DeFi protocols
is likely to be the most optimal choice in terms of impermanent loss.
We start by providing an overview of how the Bitcoin blockchain works and
then focus our discussion on the Balancer protocol, Uniswap, and Curve Finance.
Throughout the research, we also stressed the significance of these decentralized
exchange’s Value functions and price definitions for the corresponding impermanent
loss formula.
From the premisses outlined in the Balancer, Uniswap V2, V3, and Curve Finance whitepapers, we establish and prove the correspondent impermanent loss formula to be used throughout our discussion leaving the Curve Finance section in
the Appendix due to the page number restriction suggested by the School. Considering that to calculate the impermanent loss, one needs to have pool token prices at a maturity date, we used a pure jump Lévy stochastic process to model the token
log price dynamics, which allows us to estimate any token price at a maturity date.
Since any market model based on a Lévy process is complex by nature, we also
provide a careful study of each stochastic process involved in the construction of
our model.
At last, we apply the derived model to a specific case, and once instances of our model are calibrated to the time series of each token, we manipulate these parameters to generate distinct market conditions, notably those that are most prevalent.
Subsequently, we conducted a comparative analysis of the corresponding impermanent losses within these protocols.
In this manner, it became feasible to estimate in which of the four decentralized finance protocols the liquidity provider’s investment would be better shielded against impermanent loss.
Trabalho final de Mestrado