Can the AMM "impermanent loss" problem be solved? Understanding Bancor's single-sided liquidity and impermanent loss insurance strategy

This article was published on Abmedia, author: Jeff.

In the past, both traditional finance and the cryptocurrency market used order book mechanisms to match buyers and sellers until the automated market maker (AMM) trading model emerged, bringing a novel trading mechanism to users in the decentralized finance space. The automated market maker (AMM) model can reduce the dependency of DEX on blockchain performance, and with sufficient liquidity, it can also achieve lower trading slippage. Most importantly, token holders can earn trading fees by providing liquidity to the AMM's liquidity pool, turning spot assets into income-generating tools.

However, the automated market maker (AMM) has an inherent flaw: liquidity providers must bear "impermanent loss (IL)." Taking Chainlink tokens as an example, from April 2019 to August 2020, the price of LINK tokens increased by over 3,700%, which led to liquidity providers in the LINK/ETH pool losing more than 60% of their asset value compared to simply holding the tokens.

Source: zumzoom

Due to the significant impact of impermanent loss on long-term liquidity providers, many development teams are dedicated to creating solutions in this area. However, among so many AMM projects, the only platform that can effectively address impermanent loss and offers good usability may be Bancor after its V2.1 update. This article will explore how Bancor addresses the pain point of "impermanent loss."

Introduction to Bancor and Current Performance

Bancor is one of the older AMM projects in the market and a pioneer of the automated market maker (AMM) model. Unlike platforms like Uniswap or SushiSwap, all liquidity pools on Bancor must be paired with BNT, such as WBTC/BNT, ETH/BNT, USDT/BNT. This means that BNT serves as a connection or path between all TKNs (ETC20 tokens, short for Token), for example: TKN A -> BNT -> TKN B. The lack of incentives for liquidity providers to buy and hold BNT has made it difficult for Bancor to compete with platforms like Uniswap or Kyber that allow for free selection of collateral tokens.

However, it is precisely because Bancor has adhered to this model design from the past to the present that it was able to solve the "impermanent loss" problem in its recent V2.1 update, which is the main reason for the significant growth seen in Bancor's locked assets and trading volume data in the following charts.

Bancor's locked assets have significantly increased:

Source: Dune Analytics

Bancor's monthly trading volume has significantly increased:

Source: Dune Analytics

V2.1 Version Update

The main changes brought by the V2.1 version update for liquidity providers include: "support for unilateral liquidity provision" and "impermanent loss insurance" (both features are limited to whitelisted pools).

Source: Bancor

Unilateral Liquidity Provision

In the past, providing liquidity on Bancor required holding an equivalent value of BNT, which deterred many liquidity providers. Therefore, in the V2.1 update, the development team implemented the "unilateral liquidity provision" feature through a flexible supply model, allowing liquidity providers to choose to provide liquidity in either TKN or BNT without needing to prepare both assets at once, which is not achievable on other platforms.

The so-called flexible supply model means that when liquidity providers inject TKN liquidity into the TKN/BNT pool, the protocol will automatically mint additional BNT to make up for the BNT that should have been provided by the liquidity providers. These newly minted BNT will be retained in the liquidity pool and will be burned when liquidity providers withdraw their TKN tokens.

On the other hand, in addition to providing TKN liquidity, BNT holders can also choose to stake BNT to provide liquidity. When there is external BNT inflow (BNT holders staking), it will replace the BNT minted by the protocol, forming a trading pair with TKN, and the BNT minted by the protocol will be burned due to being replaced.

While the flexible supply model enables the "unilateral liquidity provision" feature, the minted tokens are controlled by the protocol and can only be used as liquidity in the pool. Additionally, the flexible supply model has a hard cap on the amount minted, and the value is determined by the decentralized governance organization. Furthermore, the flexible supply model can be seen as a joint investment between the protocol and liquidity providers, as providing liquidity can yield trading fee income, and the fees earned by the protocol will be used to burn BNT. Therefore, the amount of BNT burned will exceed the original amount minted, increasing the scarcity of BNT.

Impermanent Loss Insurance

The flexible supply model is also the core foundation for Bancor to address the impermanent loss pain point. The "impermanent loss insurance" allows users providing TKN liquidity on Bancor to enjoy "trading fee income" while the protocol can compensate users for any impermanent loss they encounter, but certain conditions must be met to receive 100% coverage for impermanent loss.

Only TKN in whitelisted pools can enjoy impermanent loss insurance, which can be directly checked on the Bancor website. Pools with a blue shield are eligible for impermanent loss protection.

Source: Bancor

Liquidity must be provided for 30 to 100 days. Liquidity providers who have not provided liquidity for at least 30 days cannot enjoy impermanent loss compensation. On the 30th day, 30% of the loss can be covered, and thereafter, 1% is added for each additional day until 100 days, at which point 100% full compensation is available. In other words, only long-term liquidity providers can enjoy impermanent loss compensation.

Source: Bancor

Once the above conditions are met, liquidity providers can receive Bancor's impermanent loss insurance when withdrawing liquidity (withdrawals cannot be made midway). The cost of the insurance comes from the protocol's shared investment trading fee income. However, if the income is insufficient to fully compensate liquidity providers for their impermanent loss, the protocol will mint additional BNT as compensation, meaning the cost of insurance will be shared among all BNT holders.

Source: Bancor

Inflation Issues

Most people may notice after reading Bancor's solutions that both the "flexible supply model" and "impermanent loss insurance" involve minting additional tokens as a solution. Does this lead to inflation and dilute the value of the tokens?

Regarding the flexible supply model, the minted tokens are directly managed by the protocol and are only used as liquidity in the pool, meaning they do not flow into the external market and do not cause value dilution of the tokens. Furthermore, the protocol's minting of tokens as shared investment funds can increase protocol revenue, leading to the burning of more tokens, which is beneficial for the positive cycle of the overall token economy.

As for impermanent loss insurance, the practice of minting BNT as compensation for impermanent loss may seem detrimental to the price growth of BNT. However, so far, this cost has been completely absorbed by the trading fee income generated from the BNT invested by the protocol. According to analysis from Deribit, due to the design of whitelisted pools and the restrictions on long-term liquidity providers, for every $1 of trading fee income earned by the Bancor protocol, the cost of impermanent loss compensation is only about $0.07, indicating that the current protocol design effectively provides a self-sustaining economic cycle for the ecosystem.

Source: Deribit

From various data, the protocol has not shown a trend toward inflation, and the price of the BNT token has actually been rising due to the increase in platform locked assets, trading volume, and staking rewards.

Potential Defects

Since "unilateral liquidity provision" and "impermanent loss insurance" are features that can only be enjoyed by whitelisted pools approved by the community, and the approval process for whitelisted pools is cumbersome, new projects or token holders outside of whitelisted pools must prepare BNT and bear impermanent loss when building pools on Bancor. This limitation is designed by the development team for the security of the protocol, but it is also the biggest weakness for Bancor in competing with Uniswap and Sushiswap.

Future Plans

In fact, in addition to the two main features shared today, Bancor also possesses functions such as automatic reinvestment of mining rewards and Bancor Vortex (leveraged financing), creating ample token empowerment and holding incentives for BNT tokens. Moreover, in the face of strong market competition, the Bancor development team plans to launch more different new products in the future, including: Origin Pools (similar to SushiSwap's Onsen), Shadow Token stablecoin pools (competing with Curve's stablecoin trading pools), second-layer scaling solutions, cross-chain trading, etc. This relentless innovation may be the main reason why Bancor is referred to as the dark horse of DEX.