Half of Uniswap v3 Users Lose Money — Here's Why

Uniswap has revolutionized crypto by introducing the concept of DEXes. However, the platform has also created a new risk for users that provide liquidity to them called Impermanent Losses.

Impermanent Losses (IL) are commonly known but do not get serious attention from most liquidity providers. Around 49.5% of the Uniswap v3 liquidity providers not only cannot make a profit due to high IL, but they also lose money at the end.

For all of these investors, it will be more profitable to hold their tokens without investing and wait for a moment when they will grow. This solution looks counter-intuitive when we can see APY around 30% in some Uniswap v3 pools. But the data show that higher APY is also commonly paired with higher ILs.

In most pools, IL is bigger than the rewards that this pool can generate from fees. On average, IL is 130% of the fees that pools earn. It means that even in pools with high trading volume and big TVL, an average liquidity provider (LP) cannot expect to make any profit.

How to be in plus

Even if half of the investors are losing money, another half is making them. There are main solutions that investors can use to make their investment profitable:

• “Rebalancing” is known as a popular solution to reduce LPs. Theoretical traders or smart contracts that adjust their position 24/7 could make their investment profitable in most of the pools, but in reality, it is not so straightforward. Data shows that, on average, users, who actively monitor and adjust their positions daily, lose 70% more than those who hold their position for a month or more.

• Holding your position for months looks more profitable on average. But still, such LPs experience impermanent losses of around 110% of the fees they earn. It means that if the trader is patient enough, he can take a good spot to capture his impermanent losses at the best time when they will be lower than fees.

• The most promising solution is to choose the right pool to invest in. But choosing such pools is very hard. Except for the size, these pools do not have any pattern. Around 17% of analyzed pools have produced more fees than IL to their holders. They all have mid-size TVLs between $2m — $8m. Pools have purely altcoin pairs on par with stablecoin-to-altcoin pairs. Fees also vary, between 1% and 0.3%. Only advanced analytics can give signs, which pools in reality make money.

• A consistently profitable solution is also known but is even harder to implement than the previous one. Just-In-Time (JIT) liquidity provision allows for earning positive returns in all pools. It is done by providing liquidity for a single block, absorbing fees from upcoming trades, then instantly removing their position. LPs that use JIT can earn rewards while not experiencing any Impermanent Losses. But such a solution can be profitable only for a large amount of money.

  
  

I will describe each solution in depth further. Each has pros and cons, which you must consider before investing. Research excludes stablecoin-only pools, as they commonly do not have noticeable impermanent losses.

Before we begin

This post is based on one of the most detailed research on Impermanent Losses in DeFi. Our team analyzed this research to more deeply understand impermanent losses. I decided to share our findings in the hope that they will help someone save money on investments. This post is not financial advice of any kind, and any mentioned protocols and data are provided only for information purposes. Also, while the research was conducted 4.5 months after the Uniswap v3 launch, TVL and volumes in the protocol have grown since then. On the other hand, ratios are very similar and can still be used to understand how to deal with ILs. I extrapolated most of the numbers to make them easier to compare.

Why “active” investors lose more

Around a quarter of liquidity providers use rebalancing strategies to reduce impermanent losses, but on average, they only increase their impermanent losses.

Notice the “flash” bar? It is a Just-In-Time (JIT) liquidity position. I will explain them in detail further in the post.

In the chart, 1d-1w means the account had positions that were active for over one day and less than one week. If the position was adjusted daily or weekly, impermanent losses still significantly outperform fees. All of them, on average, experience IL of around 1.8x higher than the fees they captured. The hourly or monthly adjusted positions look better, but they are still negative.

Only positions that have existed for more than a month are close to being positive. They have a ratio of IL to fees of around 1,1x. It gives enough confidence to expect in the long run, holding position can be positive. Investors can find the right moment when the position ratio will return close enough to the initial ratio while collected fees will overcome resulting ILs. But it also means that we cannot expect high returns on investments, with such a high chance of investments being negative.

Expected results for investors that actively rebalance their position are much smaller IL than for passive holders, but in reality, we can see the opposite picture. There is always a chance that “active” investors weren’t trying to optimize their position. Still, the most likely variant is that they failed to react to pool condition changes fastly enough and optimize their position precisely enough.

Which type of Impermanent Losses are possible to minimize

Rebalancing actually cannot remove all ILs, but only a specific type.

Types of Impermanent Losses

• The minimal IL — is a loss that the position suffers while it is in the position price range. While position earns fees, the price in a pool changes, which means asset ratios also change. When the price falls out of the range, the position is only left with one asset and not earning trading fees until the price reenters the range. The difference between the dollar value of the current asset amount and the initial position is a minimal impermanent loss. This IL is unavoidable but can be reduced by decreasing the position price range.
• The out-of-range IL — is a loss that the position incurred when the pool price exceeds the position price range. While the position ratio is frozen in overweight to the falling asset, the position does not earn any fees. The difference between the dollar value of the initially supplied position and the frozen position is the out-of-range impermanent loss. This loss can be avoided without any losses in profit by withdrawing the position after it goes out of range and repositioning it back with a new ratio.
• The actual IL — is simply the sum of the minimal IL and the out-of-range IL. It is an end IL that liquidity provider faces.

Any rebalancing strategy cannot remove impermanent losses at all, but it can remove out-of-range IL. It means that the strategy captures minimal ILs, which can lead to increasing ILs instead of reducing them in some situations. Also, rebalancing requires a fast reaction to price changes. But even if all actions are implemented properly and in time, it still does not mean that the liquidity provider will have positive returns. In some pools, minimal IL is bigger than the fees this IL produces anyway.

The chart shows the difference between IL and fees captured by pools. The blue column shows fees, while the orange shows the actual ILs. A white line marks the minimum IL. You can see already the third by total fees pool, WBTC-WETH, with a 0.3% fee level, has minimal IL bigger than the generated fees.

Problems with rebalancing do not stop with choosing the right pool. The first part of rebalancing is withdrawal, which means we “crystalize” the impermanent losses we already have, meaning they are no longer impermanent. At this moment, we already need to have a bigger amount of fees collected than IL, which we capture.

Additionally, rebalancing requires the position to be in the ideal size range:

• After withdrawal, we must swap part of the token to reach the initial position distribution. This swap on big positions can cause substantial price slippage, creating higher losses than IL itself.
• In the end, we need to deposit a new position, which gives us a total of three transactions per rebalancing cycle. The gas costs of all these transactions can make them useless for small positions.

Even if, on each iteration, investors correctly identify the right moment to make rebalancing and always make it with minimal slippage and acceptable transaction fees. It is not enough to reach this theoretical “white line” of minimal impermanent losses. To be able always to sustain these theoretical ILs, the position must be monitored and adjusted 24/7.

All these requirements make rebalancing useful only in an automated way. This fact was noticed long ago, and many smart contract protocols already automate rebalancing for their holders. For example, one of the biggest is https://arrakis.finance, specifically focusing on Uniswap v3 rebalancing.

Good VS Bad pools

You probably already noticed that some pools produced more fees than actual ILs. These pools are rare. Only 3 of 17 analyzed pools have IL lower than fees. It made their LP much more likely to have positive returns. But not only does IL contribute to the probability of having a positive return on investment (ROI) in the pool, but also the volume of transactions and fees level in the pool. It is logical that if the level of the fees we know, IL and volume is hard to predict.

In the chart, only 6 pools have a number of positive LPs higher than 50%. On the total average, both negative and positive LPs are between 40–60%. It means if we invest without confidence in pool returns, we can expect a negative return with almost 50% probability.

Also, the bigger percentage of positive returns logically causes a bigger percentage of returns to investors.

On the left chart, you can see the mean positive return (green) and mean negative return (red) per wallet.

As you can see, they’re hard to notice any pattern between pools with higher returns. Positive and negative pools equally have altcoins and stablecoins in pairs.

The pool with the best average positive return is FTM-WETH with a 1% fee, which generated a 2.6% ROI. These returns were collected for the first 4.5 months of Uniswap v3 work. This translates to a yield of about 6.9% APY. It is good, but not 20% ROI or 53% APY, which this pool generates directly in fees before IL. You can see a significant difference between the ROI of pools before and after impermanent losses in the next chart.

This chart shows the total ROI which pools generated before any impermanent losses. You can see on top WETH-USDT pool with a 0.3% fee. This pool generates over 30% ROI in the first 4.5 months, which is around 80% APY. But also in the previous chart, we sow the average positive return in this pool is 0.9% ROI, which is just 2.4% APY. And it is even good cases. Around half of the users in this pool lost, on average 1.8% of the invested money.

It is enough serious sign that before investing in DEXes like Uniswap need check not only average fees APY but also average IL. This problem is known but only partly solved. One of the best yield analytics tools, https://apy.vision/, currently provides APY and IL analytics only for Uniswap v2. And also, https://defillama.com/ provide APY analytics for Uniswap v3, but it doesn’t cover ILs.

This analytics can be valuable to understand and expect APY in other DEXes as well. It, of course, is not enough to make predictions in the future, but enough to decline variants that are lucrative only at first glance.

Why does Just-In-Time liquidity not have IL?

JIT liquidity is a specific type of liquidity-providing strategy. This strategy is executed only in an automated way, with the help of smart contracts and Flashbot auctions. This strategy requires monitoring all swap transactions in Uniswap v3 pools. When there found a big enough transaction, which had not yet been processed:

• LP sends a transaction with bigger fees than the target swap transaction. This new transaction deposit liquidity is concentrated exactly around the price range where the swap will be executed. The deposit transaction will be executed before the swap transaction but in the same block.

• LP lets the swap execute and receives a fee in return for providing liquidity to the swap.

• After the swap, LP places a withdrawal transaction. This transaction removes all provided liquidity with collected fees. Even if this transaction is executed after the swap, it is still in the same block.

  
  

There is an example of one of the cycles. All three transactions are executed in the same block.

After all the transactions are executed, LP is left with earned fees and a portfolio of tokens, with the ratio changed from the initial one. This difference still introduces the risk of ILs. To remove this risk completely, LP executes alternative swap transactions in parallel on another exchange with a lower swap fee. This swap exchanges tokens in reverse proportion to return the total balance ratio to the initial one.

While all of these operations allow removing of impermanent losses, they are also very costly:

• Two deposit/withdraw transactions with slightly high fees for miners to execute in the target block.
• Reverse swap fee, together with a small transaction fee.

In total, they make JIT liquidity profitable only on high amounts of money. This is probably one of the main reasons why JIT does not get high popularity.

The chart shows the total amount of JIT liquidity supplied in Uniswap v3 over time, between 5 May 2021 and 18 July 2022. JIT liquidity provided a total of over $2bn dollars of liquidity, but it is just ~0.3% of all Uniswap v3 liquidity during this period. Even that, over 95% of JIT liquidity was supplied by one single account.

While, economically, JIT liquidity can be profitable, there is no available solution to use it.

How DeFi is Solving Impermanent Losses

Impermanent losses are a pain point for investors in DeFi. However, existing projects can only reduce ILs for liquidity providers in specific scenarios. At Eonian, we believe eliminating impermanent losses is critical to prepare DeFi for mass adoption. New users should not have to worry about IL when investing in DeFi.

This is why we decided to build a yield aggregator that distributes liquidity in the most profitable way for liquidity providers. Our protocol will simultaneously use rebalancing, insurance, buffers, and JIT liquidity to remove impermanent losses.

More info

• Research “Impermanent Loss in Uniswap v3”
• Uniswap team post “Just-in-time Liquidity on the Uniswap Protocol”