Divergence loss (also known by the misleading name “impermanent loss”) happens in a liquidity pool position when the relative price between the two assets in a liquidity pool changes. The bigger the relative change, the bigger the loss.
While it may seem strange to consider you can lose tokens by providing liquidity, this is an inherent characteristic of automated market makers. As trades are made in one direction, the balance of one asset in the pool increases while the other decreases. While providing liquidity to a liquidity pool is often profitable, you’ll need to be very mindful of the concept of divergence loss.
The Sovryn protocol allows any adequately funded user to become a market-maker and earn trading fees. From time-to-time, liquidity providers (LPs) can earn additional liquidity mining rewards during special promotions. Market making enables a frictionless market with growth potential within the Sovryn protocol.
Below you will learn everything you need to know about one of the most important concepts when it comes to providing liquidity – divergence loss.
Divergence loss happens when the relative price between your deposited assets in a liquidity pool changes compared to when first deposited. The bigger the change, the more you will experience divergence loss. This does not necessarily mean your LP position has lost value. If divergence loss occurs, it simply means your position has less value at the time of withdrawal than if you had simply held the assets in the original quantities from the time of deposit. That could mean you lost more than if you had simply held or that you gained less.
Assets that remain relatively stable with small small price fluctuations are less subject to divergence loss. For example, stablecoins usually stay in a tightly contained price range. So stablecoin pools are significantly less risky when it comes to divergence loss.
The simple answer is, divergence loss is often offset by earning trading fees. Thanks to trading fees, even pools with tokens that are quite exposed to divergence loss can be profitable.
Let's deposit 1 of token “A” and 100 of token “B” in a liquidity pool. First, let's make a few assumptions:
Based on the assumptions above, the total dollar value will be $200 at the time of deposit.
Let's also assume, other LPs have already funded the pool with a total of 10 of token “A” and 1,000 of token “B”. In this case, we currently have a 10% share of the pool, which has total liquidity of 10,000.
If the the price of 1 token “A” increases to the equivalent of 400 token “B”, the ratio between how much token “A” and token “B” there is in the pool has changed. As a result there is now 5 token “A” and 2,000 token “B” in the pool.
If we decide to withdraw our funds, we are still entitled to a 10% share of the pool. As a result, we can now withdraw 0.5 of token “A” and 200 of token “B”, totaling $400. As you can see, we made a decent profit since our initial deposit of $200 worth of tokens, but what if we simply held our 1 token “A” and 100 token “B”? If we simply held the tokens, we would've had a combined total of $500.
We would have been better off holding rather than depositing into the liquidity pool. The $100 difference is the divergence loss.
Our example does not take into account the trading fees we would have earned for providing liquidity. Earned fees can negate losses and result in profits. That said, it’s important to fully understand divergence loss before providing liquidity to a pool.
It is important to understand that divergence loss happens regardless of which direction the price changes. The only thing that for divergence loss is the price ratio relative to the time of deposit.
Divergence losses become realized/permanent only when you withdraw your tokens from the pool. Fees you earn may offset the losses.
Be mindful when depositing funds into one of the liquidity pools. As outlined earlier, certain liquidity pools are more subject to divergence loss than others. As a general rule, the more volatile the assets, the higher your risk of exposure to divergence loss.
Newer AMM pools such as Uniswap V3 and Sovryn pools on BOB allow for concentrated liquidity. This magnifies the amount of assets that can be swapped for a given price impact. Users who participate in concentrated liquidity provision earn more fees in proportion to the magnified liquidity impact. However, that impact also magnifies impermanent loss for given price moves. For details on this phenomenon, see Impermanent Loss in Uniswap V3.
Divergence loss is a the fundamental concepts that should be fully understood by anyone who wants to provide liquidity to the Sovryn protocol. Keep this key point in mind, if the price of your deposited assets changes, up or down, you will likely be exposed to some degree of divergence loss.