The risks of impermanent loss in automated market making
Impermanent loss, or divergence loss, occurs when a deposit becomes unbalanced, and you end up with lower net value than you would have, had you held only one token in the pool. In stable and pegged vaults, impermanent loss is negligible, or non-existent. However, it occurs to a greater degree in non-pegged vaults.
Impermanent loss is a law of the markets you can’t change, you can only hedge against it.
How impermanent loss works:
- If you deposit 50/50 into a mixed vault like SOL/DUST, and the SOL price increases more than the DUST price, you will likely end up with more DUST in your position than SOL. If you had simply held SOL in your wallet, you would have had a higher net increase than you did by having your deposit in the pool.
- In a pool with a volatile asset and a stablecoin (not yet present on Kamino), you will likely end up with more of the stablecoin if the price of the non-pegged asset (eg. SOL) increases. Similarly, you would have had higher returns if you simply held the non-pegged asset in your wallet.
You will always experience impermanent loss in non-pegged vaults if the asset prices diverge. However, impermanent loss is not permanent, and can be recovered if the asset prices converge again without triggering a rebalance. If a rebalance occurs, impermanent loss is realized.
With pegged assets, Impermanent Loss has been, empirically, much less, or it is offset by earnings.
As an example of how impermanent loss could work in a stable or pegged vault:
- Starting with USDH-USDC, say the price is exactly 1.000 and therefore you’re deploying equal amounts of both tokens.
- Once funds are deposited into the vault, depending on market changes, the ratio of tokens can fluctuate depending on market price and rebalancing activity.
- If, for example, USDH starts trading at a premium, with the price going to 1.005, then the proportion of the pool will be more weighted towards USDC, and when you withdraw, you will withdraw more USDC than USDH. In this example, and for stable and pegged assets, this has minimal impact. You end up withdrawing two assets that are so close in price to each other that it almost doesn’t matter.
- It’s worth noting that when withdrawals are made, users can choose a single asset to be withdrawn, and Kamino will auto-swap the whole position to the preferred asset. The auto-swap happens using Jupiter.
Kamino's quantitative model is optimized to select ranges for Mixed Strategies that allow for a generous measure of price divergence before rebalancing occurs. If asset prices do diverge to a point where the liquidity is no longer in range, and thus earning no fees, a rebalance can be triggered. Rebalances are automated, and new ranges are determined by Kamino's quantitative model.
If a rebalance occurs, all the liquidity is withdrawn from a position, and redeposited into the new, optimal range, identified by the quantitative model. When a rebalance occurs, impermanent loss is realized. This means that liquidity is deposited into a new range, and any impermanent loss experienced in the previous range is now made "permanent."