Impermanent loss is considered by experts within the crypto-space to be the ultimate crux of DeFi. Put simply, when a Liquidity Provider (LP) provides liquidity into a pool, which represents a 1:1 valued ratio of two coins, their principal deposit hinges on the price stability of these coins relative to one another. The divergence of either of these coins, be it through an increase or decrease in value relative to the initial deposit in the pool, results in lost earnings for LP. This is known as impermanent loss, something Sigmadex is working hard to address.
The knowledge of this significant risk in DeFi dissuades many investors from becoming LPs, and therefore decreases the total amount of liquidity that is available within the space. Without liquidity, the trading of coins through a decentralized format fails, and the results in DeFi never growing to its full potential.
Without solving this intrusive problem, DeFi may not ever propagate across the world and, consequently, Blockchain may never take its role as the world’s future financial system. While many have pondered theories behind reducing the insidiousness of impermanent loss, we believe that our creation of the Modified Dynamic AMM (DAMM) has solved the problem in actuality.
Impermanent Loss Solved
In respect to the fact that vague promises are vast within the crypto-space, we at Sigmadex would like to explain to you exactly how, from a mechanistic standpoint, we have finally solved the age-old problem of impermanent loss.
As you can imagine, there are many moving parts to our system, and none of them are exactly simple in design. However, it is our intent within this article that, while a basic understanding of certain blockchain and DeFi concepts would definitely ease the digestibility of the content, any reader should be able to understand how these mechanisms, when combined, have the effect of significantly reducing impermanent loss for LPs.
First, we utilize Chainlink V2 to calculate the implied volatility of any one liquidity pool. From this, we fluctuate the transactional fees for coin pairs or each individual coin based on this implied volatility, meaning transactional fees will rise when volatile to promote stabilization of the pair, and fees will lower if stability is maintained.
Utilizing implied volatility, instead of explicitly calculated volatility, means that Sigmadex can proactively raise the transaction fees to counteract arbitrage opportunities, rather than acting reactively where a large deal of arbitrage could have already occurred.
What’s more is that by proactively changing transactional costs, arbitraging actually benefits our ecosystem! This is because through changing the buy/sell transactional fees for each coin of the liquidity pair independently, arbitrageurs actually provide value by balancing the liquidity pair through being incentivized to buy/sell the token that has diverged away from the other.
However, this implied volatility reactive set-up is only a piece of the Impermanent Loss puzzle. The second part involves something we call Forced Rebalancing.
When a Sigmadex liquidity provider withdraws their liquidity before the end date of the smart contract lock-in period, they will be penalized in the form of having to pay back a portion of their initial liquidity deposit back into the ecosystem. This liquidity is re-distributed into smart contracts that are 1:1 tethered to a liquidity pool, otherwise known as the Impermanent Loss Insurance Pool, which acts to supply assets to whichever token in the pair reduces in value.
Utilizing the Constant Function Market Maker (CFMM) model, this form of exchange rate evaluation from individual liquidity pairs will resist any quick changes in volatility within any liquidity pool. Essentially, the model works by making it so aggressive that trading in any one liquidity pool actually disincentives the trader to continue, as their trading exchange rate will become less favorable over the course of the aggressive trading. Put simply, if one was going to trade in a BTC:ETH liquidity pool, and was buying ETH for BTC, the more ETH bought with BTC in this pool would result in proportionally lower amounts of ETH being bought for proportionally more BTC needing to be sold for the trade. Therefore, as the size of purchases from any one buyer increases, the favorability of the trade reduces (as depicted in the graph below).
All in all, this model both independently decreases volatility in our liquidity pools, as well as provides more time for our Chainlink V2 Implied Volatility to change transaction fees, and our Impermanent Loss Insurance Pools to rebalance the assets in any one liquidity pool.
Finally, we have two components that need to be discussed, in order to fully understand how the Sigmadex infrastructure has the ability to truly remove impermanent loss from the future of DeFi.
First, Sigmadex sets minimum trade amounts on any one liquidity pool. This is in an effort to ensure that the negative actions of arbitraging are severely hampered, and that the positive actions of arbitrage, through our Implied Volatility mechanism incentivizing arbitrageurs to rebalance the liquidity pool, can still occur at a rate needed to battle impermanent loss for our LPs.
Second and final; To prevent frontrunning which is essentially various ways a malicious actor can profit from changing the transaction queueing on a network, Sigmadex will restrict gas fees. The most popular form of Frontrunning is when malicious actors will often increase the gas fees associated with their transaction to get ahead of another transaction in the mining queue, in an effort to profit from this change in queueing. However, with Sigmadex’s protocol, increasing your gas fees will no longer give you priority in the queueing list. Put simply, Frontrunning for profits will no longer occur within the Sigmadex network.
As one can see, there’s many mechanisms that need to work in unison in order to prevent impermanent loss and, ultimately, reduce monetary risk to LPs within DeFi. Herein lies these mechanisms, and we believe our system design will put forth the new age of DEXs, one where passive earnings can be both enhanced and secured. As a result of these assurances, more investors in the space will consider a LP as a profitable venture, and will inject more liquidity within the space. A higher degree of liquidity within the entirety of the crypto-industry means DeFi can run as intended, and through successful use of the Sigmadex Modified DAMM protocol, blockchain can continue on its rise as the new financial medium across the world.
To learn more about Sigmadex, check out our website. For the savvier mathematical and/or computer science readers, check out our Lightpaper for an in-depth explanation of each of our components whose validity is verified through auditable mathematical equations.