A friend sent me a video of a man who was yield farming for 2000%+ annual percentage return (APR). The question I got was simple enough: what’s the catch?
To paraphrase his analysis he wrote basically the following.
“I mean, even if that APR drops to “only” 100% a year, isn’t that the goal of The Art of the Bubble? Why bother investing if yield farming will give you what you want?”
“Yes, yes,” he acknowledged. “People always say stuff about “impermanent” loss. But doesn’t that just mean losing relative to what you might have earned if you were holding onto the coin? Say you’re yield farming Ethereum for 100% APR and the coin goes up 400%. Assume that because of impermanent loss, you only get the 100%. What’s so bad about a 100% return?”
My reply is simple: if yield farming could reliably give you those yields, and if impermanent loss worked that way, then it would be amazing.
The purpose of this lesson is to explain how things actually work so that you find a real strategy to make 100% or better returns on dead money (i.e. money in an investment that isn’t otherwise growing).
My paid subscribers have already seen how I do this in their weekly newsletters, but I didn’t really explain it.
If you’re a Do It Yourselfer (DIY-er) on Patreon, you can ask follow up questions about each lesson on Discord. If you are a Crypto Rider or Bubble Rider on Patreon, you can ask detailed questions about the trades themselves.
And if you are a legacy subscriber here on Substack, be sure to add the corresponding Patreon Subscription. In August, I won’t have any way to communicate with paying subscribers except by Patreon.
Everyone’s going to benefit from this, though, so let’s start with the basics.
Basic Terms
My friend had the idea partly right. Impermanent loss is a bit closer to “relative” loss than anything else.
Pintail, who dubbed the phenomenon “impermanent loss” originally, later changed his mind to call it “divergent loss.” They’re both inaccurate though.
To make sure that everyone is on board, let’s nail these terms down with some actual examples.
Uniswap was among the first decentralized exchanges on the Ethereum blockchain. Unlike ordinary stock exchanges, which are centralized and so have a buyer and a seller, these decentralized exchanges are automated.
Ordinary exchanges (for stocks or cryptos) have “money makers.” These are (roughly) the people who make sure that you can sell the stock you want when you want, or buy it when you want.
Decentralized exchanges need to automate the money makers’ work, so they use what are called “automated market makers,” abbreviated as AMMs.
In order for these AMMs to work, they need people to supply each of the token pairs they are going to exchange. So, for example, if someone wants to buy Ethereum using the DAI stable coin, the AMM will need a pool of people who supply both Ethereum and DAI.
That pool of funds that provides the desired coins is called a liquidity pool (LP). But how do they get people to “donate” their coins for a time?
Well, if someone is going to get me to lock up my coins for a time, I’m going to need to get paid. And that’s what AMMs do. They give anyone who supplies tokens to the liquidity pool a cut of the exchange fees.
LP staking, then, is just supplying your tokens to the liquidity pool of an AMM in exchange for a cut of the fees.
So, with these terms in mind, let’s turn to the problem at hand: how does “impermanent loss” work? Let’s begin with an approximate story.
The Simplified Version of “Impermanent Loss”
Because an AMM is decentralized, it can’t connect to ordinary exchanges to check that its prices are right. Instead, it relies on people buying and selling to keep the prices in check.
If Ethereum is selling for $2000 on centralized exchanges, but $1900 on an AMM, then people can buy the Ethereum (exchanging a stable coin like DAI) on the AMM and sell it at a higher price on the centralized exchange. It’s basically free money.
That free money is an arbitrage play (which we know about in this series). A few large firms have already invested in software to monitor for these differences and automatically buy and sell as needed to make money for themselves. So, this happens on its own.
To illustrate how this process results in losses, let’s use some round numbers.
Suppose that you are interested in providing liquidity to an AMM by using the Polygon token MATIC and a paired coin is DAI. Both are worth $1.
You see that your AMM is providing a 50% APR for this paired combination, so you decide to provide $1000 of each coin (so $2000 total). What could go wrong?
To make the math simple, let’s assume that the total pool only has 10,000 of both coins ($20,000 total), meaning that you own 10% of the pool (you crypto whale).
Now suppose that the price of MATIC takes off and is worth $4 a coin. In that case, the AMM has to change the ratio of the coins in the pool to adjust for the price, since the total liquidity in the pool remains constant.
Some math transpires here that I’m skipping for the moment about how this rebalancing is calculated.
There will now be 5000 MATIC (rather than 10,000) and 20,000 DAI (rather than 10,000). Since you own 10% of the pool, if you withdraw your stake, you’ll get 500 MATIC and 2000 DAI, for a total of $4000, which is a literal doubling of your initial price.
Great! Your investment paid off. But had you just held MATIC and DAI, you would now have $5000. So, you would have done better holding the coins separately. That worse outcome is the result of what is called “impermanent loss.”
So, it looks like my friend is right. Impermanent loss is just relative to what you would have made. What’s wrong with it?
The Real Story
The real story is that there is one phenomenon, most accurately called price divergence, which results in four kinds of possible loss:
Relative Loss
Impermanent Loss
Amplification Loss
Nullification Loss
The story above is a case of relative loss, and my friend is right for that scenario. But he’s mistaken to think that all such loss is like that.
Let’s start with the basic phenomenon: price divergence. What’s really happening is that liquidity pool rebalancing results in a loss to the liquidity providers if there is a large divergence between the prices of the coins.
The pool rebalances by following a ratio that is expressed as the relationship between two algebraic equations that represent the holders of the liquidity pool. The math isn’t that hard (it’s just algebra), but I taught that subject to high schoolers for a few years in my twenties and vowed never to do so again (I worked for a test preparation company).
So, if you like math, just read this.
The upshot of those details is what matters. Any time the prices between the coins diverge by a lot, the LP providers (you) lose money relative to just holding the coins. How much?
Well, the Binance website has a nice graph to express the relationship between impermanent loss and your net position (excluding accumulated fees).
To give you another way to think about those losses, here are some price points.
1.25x price change = 0.6% loss
1.50x price change = 2.0% loss
1.75x price change = 3.8% loss
2x price change = 5.7% loss
3x price change = 13.4% loss
4x price change = 20.0% loss
5x price change = 25.5% loss
Remember, so far, these are losses relative to just holding the coin -- so this is what I’m calling Relative Loss that results from price divergence (Case 1 above).
Impermanent loss (Case 2) is the happy and unlikely scenario that the coins return to their original price level. Because the price divergence disappears, your loss also disappears--it was “impermanent.” Yay! This almost never happens though.
Case 3 is amplification loss. Here is an actual person who was staking Ethereum and DAI on Uniswap. This image, from Pintail’s post, includes the impermanent loss suffered from Ethereum’s price movement, Ethereum’s price, and the accumulated fees.
What happened, in this case, is not only that the coins diverged in price, but that Ethereum took a substantial dip—more than 50%. Even including the fees earned from staking (that’s the yellow line) the person was losing money.
Not only can you experience loss from coins diverging in price going up, but you can also experience it when they go down. What’s worse is that your losses are amplified going down—resulting in greater losses than you would have had otherwise.
Case 4. That’s not even the worst case though. For cases using really sketchy coins, like the polyDoge + QUICK pair that my friend identified, which offered the juicy 2000%+ APR, if one of those coins goes to zero, say because of an implosion, then your whole investment is nullified and is worth nothing. This is nullification loss.
So, yeah the guy in the opening video is exposing himself to loss nullification in addition to loss amplification—and it’s not clear he understood that.
Does that mean you shouldn’t do LP staking and just ignore those yields? No. But you need to think about them systematically. Let’s go over some solutions.
Two Partial Solutions
The cause of all these possible losses is price divergence between the coins staked. If you can just eliminate that, then you’re good.
Balancer has offered people the option of using pools of coins, where you stake up to 6 coins, to stabilize losses. The idea is that the divergence of the overall pool will be less than that between two individual coins.
Here’s an image of their yields and opportunities on the Polygon blockchain as of a couple of days ago.
It’s not a great solution, though, because if one of those coins implodes, the whole basket is nullified. Also, if one of those coins loses a lot of money, causing a large price divergence, then the basket suffers a lot of price divergence (= at least relative loss).
Another solution is to use Bancor. This platform protects against divergent loss. You’ll have to lock up your funds for 100 days, but you won’t suffer the four kinds of loss discussed above. Here’s an image of their offerings.
The catch is that you can only really get nice yields staking Bancor tokens (BNT) and you’ll get paid in BNT.
So, if you only want to invest in BNT, then this is your solution. If you’d like to invest in more than that one token, you need to look elsewhere.
A General Solution
Remember, our goal is to eliminate divergence between the coins staked. So, what if you could find a token that you knew wasn’t going to move that much? What if you could find a “dead money” token?
In that case, you could buy the dead money token, pair it with a stable coin and stake both. Your yield would then be 25% - 45% on that pair and it would be real. That sure beats just putting your stable coins on a lending exchange.
Where do you find that? Synth stocks.
Synth stocks are just representations of stocks on a blockchain platform. Here are some examples from the terra.mirror.finance/farm platform.
What you’re looking at are the yields you’ll receive for farming those synths.
You just buy the synth (on the platform), and stake it with an equal amount of UST (a stable coin) on the platform and collect the reward.
If you pick a stock that you know won’t move much, then you’ll have almost no divergence loss, you’ll get those nice fat yields, and when the bull returns, you’ll make even more money on your payment tokens (you are paid in Mirror tokens).
It’s also not hard to see how you could make between 25% and 45% yield farming with these. And we just need one more step to get over that 100% return in the title.
Concluding Thoughts
To make good on the title of this article, let me explain how this turns into 100% or better returns.
Suppose you decide to try this strategy and stake $3000 for 33% APR on the Mirror platform. In that case, in 12 months during the crypto-winter, you make $1000 in Mirror tokens. You then unstake and keep your Mirror tokens
Then, in the next bull run Mirror returns only to its previous all-time high, and you get “only” 3x. Well, in that case, your investment is in Mirror tokens has grown to $3000, giving you a 100% return + having your other $3000 from your initial investment.
If you then reinvested your initial $3000 in Ethereum (say), and that does just 2x in the next run (not even breaking its all-time high from May 20201), you’ll have $3000 more, for a total of $6000 on your initial $3000 investment.
If these coins actually break their previous all-time highs, you’ll end up with lots more money, probably 10x or more. But that’s all gravy. The “meal” of this investment strategy is good enough that it’s presently one of my favorite plays in the cryptocurrency space.
If you’ve followed me this far in this long lesson, then you’ll have an obvious question at this point: which synth stocks should I pick?
Well, if you’re a DIY-Subscriber, then feel free to ask me some questions about the general strategy on Discord. You’ll need to do a little research on stocks that don’t move much historically—ideally less than 25% during any given year on average. That’s the general target for you to do your own research.
If you are a Crypto Rider or Bubble Rider, then you can ask me about my own specific favorites. In fact, you’ve already been receiving the answer in your Weekly Bubble newsletters without knowing it.
That’s it for this week! Happy Trading!
Disclaimers
General financial disclaimer: This post is provided for entertainment purposes only. I am not giving you financial advice and I am not a financial advisor. You should expect no financial returns one way or another based on my statements. These points hold equally for any statements that could be attributed to The Art of The Bubble or any related business entities. If you decide to buy or invest in anything, then your returns and potential losses are your own. No statements about taxation are taxable advice and you are encouraged to consult your own tax professional. You are also encouraged to do your o