Impermanent Loss

Impermanent Loss (IL) is a fundamental concept for any liquidity provider, but it takes on special characteristics in yield tokenization markets. Let's explore this in depth.

The Special Nature of IL in Yield Markets

In standard AMM pools (like those for trading pairs such as TON/USDT), impermanent loss occurs when the price ratio between the two assets changes from when you deposited. However, in yield tokenization pools, IL has unique properties due to the convergence behavior of PTs.

Unlike regular trading pairs where assets can move independently indefinitely, PTs and their underlying assets have a mathematically determined convergence point: at maturity, the PT price will equal the face value. This creates a "pull to par" effect that fundamentally changes the IL dynamic.

In FIVA pools, IL can still occur but is generally more bounded and predictable than in standard pools due to this convergence property. Based on analysis of similar yield tokenization protocols, the maximum IL in these pools typically ranges from 1-3%, which is significantly lower than what might be experienced in standard crypto trading pairs.

How IL Develops in Yield Tokenization Pools

Impermanent loss in FIVA pools can develop through several patterns:

1. Early Pool Volatility: When a new pool launches, there's often a period of price discovery as the market determines the appropriate discount rate for the PTs. This period may see higher volatility and consequently higher IL for early liquidity providers. Data from similar protocols suggests this initial IL can reach up to 2% during the first few weeks.

2. Interest Rate Shifts: When market interest rates change significantly, the relative value of fixed-rate PTs versus variable-rate underlying assets also changes. This creates divergence that translates to IL for liquidity providers.

3. Market Sentiment Shifts: Changes in sentiment about future yield prospects can cause temporary price movements in both PTs and YTs. These sentiment-driven movements can create temporary IL, though they typically mean-revert over time.

4. Yield Token Hype Cycles: When there's significant hype around the YT component (perhaps due to speculation about future protocol incentives), this can indirectly affect PT pricing and create temporary IL for liquidity providers in PT/underlying pools.

Quantifying IL Through Time

An important characteristic of IL in yield tokenization pools is its time-dependent nature. The IL experience depends significantly on when you enter and exit the pool:

• Early Entry IL Pattern: Liquidity providers who enter pools very early (first few days after launch) may experience higher IL as the pool undergoes initial price discovery. Analysis of similar protocols shows this IL typically peaks around 2% between 3-4 weeks after pool launch, but often recovers within 1-2 months as prices stabilize.

• Mid-Lifecycle IL Pattern: LPs who enter after the initial volatility period generally experience much lower IL, typically below 1% throughout their holding period.

• Maturity Convergence Effect: As the maturity date approaches, IL naturally decreases and approaches zero. This occurs because the PT price converges to its face value, eliminating the price ratio volatility that creates IL.

Comparing IL to Yield Tokenization Alternatives

To put IL in perspective, it's helpful to compare three potential strategies:

1. Holding PTs: No IL risk, but no trading fee revenue

2. Holding the underlying yield-bearing asset: No IL risk, but no trading fee revenue

3. Providing liquidity: Some IL risk (1-3%), but earning trading fee revenue

For many liquidity providers, the trading fees earned (typically 0.1-0.3% on all volume) often outweigh the potential IL, especially for positions held for longer periods. This creates a risk-reward tradeoff where the small IL risk is compensated by fee accumulation.

Numerical Example

Let's consider a simplified example to illustrate IL in a yield tokenization pool:

Imagine you provide liquidity to a PT/underlying pool with a 50/50 value split, with the PT initially trading at 95% of face value (reflecting the time value of money until maturity).

Now assume a significant market interest rate change causes the PT price to drop to 92% of face value. The AMM automatically rebalances your position:

• You now hold relatively more PTs and less of the underlying asset compared to when you entered

• If you withdrew at this point, the value of your position would be about 1-1.5% less than if you had simply held the original 50/50 position without providing liquidity

However, if you continue providing liquidity until maturity, this IL disappears as the PT price converges to 100% of face value. Additionally, throughout this period, you would be earning trading fees on all pool activity, potentially offsetting or exceeding the temporary IL.

Risk Management Strategies for Liquidity Providers

Given these risk factors, liquidity providers can employ several strategies to optimize their experience:

For Managing Impermanent Loss:

• Consider the pool's lifecycle stage when entering (early pools may have higher initial IL)

• Align your expected holding period with the maturity date when possible

• Monitor changes in market interest rates that might affect PT pricing

• Be prepared for temporary IL during periods of high market volatility

• Remember that IL is generally bounded in yield tokenization pools compared to standard AMMs

By understanding these dynamics and employing appropriate risk management strategies, liquidity providers can make more informed decisions about how yield tokenization pools might fit within their broader investment approach.