For a market to truly thrive a balance needs to be established that allows the various parameters of the market to function in a healthy way. With so many factors affecting the experience of a liquidity provider, the algorithms that drive liquidity platforms must be more robust than ever. The introduction of a self-tuning algorithm capable of facilitating various market parameters that responds automatically to an oracle price feed and its implied volatility would make a game-changing impact on the current DeFi space.
Impermanent Loss vs. Permanent Loss
One issue many liquidity providers run into on popular platforms like Uniswap is that of impermanent loss.
Impermanent loss occurs when an individual provides liquidity to a liquidity pool and the price of one of their deposited assets decreases in value relative to the other between the time they had deposited it, and the time they withdraw it.
The term "impermanent loss" is a misnomer as unless a price correction to the deposit value takes place, the liquidity provider will realize this loss permanently. Recently efforts have been made to replace this term with “divergence loss” to accentuate the loss incurred from the movement of the assets relative price.
Evolution of the AMM to DAMM
With automated market makers being the source of the impermanent loss woes many individuals experience in the DeFi space today, a necessary evolutionary iteration is required to tackle impermanent loss.
A self-tuning market making algorithm for transaction fees and liquidity parameters that responds automatically to a oracle price feed and implied volatility could greatly reduce the magnitude of arbitrage loss possible for liquidity pools.
When implied volatility increases the algorithm can raise transaction fees and decompress the liquidity concentrated around the market price. On the flip side, when implied volatility is low, transaction fees can be reduced allowing liquidity to become more concentrated. This careful balancing of the ecosystem can establish an equilibrium on the buy and sell sides of any asset.
On the most basic level, the precautionary nature of this type of market maker would allow the protocol to better handle future volatility expectations.
Sigmadex Balancing Impermanent Loss
Integrating implied volatility data
The goal is to create an algorithm that helps to eliminate permanent arbitrage loss from front runners leveraging changing volatility, especially in instances where values recover. Using Chainlink's upcoming implied volatility feed, as well as its price feed, as a source for data for a new algorithm to dynamically and proactively re-calibrate the equilibrium price, transaction fees, and liquidity parameters. Chainlink's V2 will provide implied volatility data through its API providing a consistent and reliable data source.
Given their implied volatility data is not out yet, it is hard to determine what form they will present their metric. Specifically, how long in the future the option expires.
Liquidity pool replenishing
Sigmadex also proposes to balance impermanent loss via a sub-pool of our existing penalty pool. The sub-pool would run in parallel to the penalty pool and exist effectively as insurance against impermanent loss on the platform. Since a portion of the Sigmadex tokens are burnt when a liquidity provider prematurely removes their liquidity, a portion of the penalties would go into this sub-pool to aid in establishing an equilibrium when necessary.
Through these mechanisms the equilibrium established can effectively mitigate impermanent loss on Sigmadex making liquidity as an investment a more viable option for individuals inside and outside of the crypto space.