SushiSwap lets you earn high APRs thanks to concentrated liquidity. It has major dangers, such as impermanent loss and active management. This guest article originally appeared on ThrowingToken.com. This review provides a comprehensive and impartial look at SushiSwap v3 so that you can determine whether it aligns with your risk tolerance and trading preferences. ThrowingToken.com brings you expert analysis on DeFi Insurance and how to solve Impermanent Loss. You’ll see people take deep-dive DEX reviews and futuristic NFT marketplace breakdowns to help keep you informed and help you earn.

Understanding Impermanent Loss

Impermanent loss occurs when the price of tokens deposited in a liquidity pool diverges from the price when they were initially deposited. In layperson’s terms, it’s the impermanent loss an LP is at risk of. This loss is realized when compared to simply holding the tokens outside of the pool. We know that this all can be confusing, so let’s explain the idea with an example.

Let’s say an LP wells equal amounts of Token A and Token B into a liquidity pool. The moment that the price of Token A suddenly increases a lot compared to Token B, arbitrage traders are unleashed. They will then use arbitrage to purchase more Token B and sell their Token A, rebalancing the pool and resulting in the LP holding less of the appreciating Token A and more of the depreciating Token B. This change in value vs just holding the original tokens is called the impermanent loss.

Furthermore, the severity of impermanent loss is directly tied to the size of that price change. The relationship between price changes and impermanent loss follows a predictable pattern:

  • 1.5x price change = 2.0% loss
  • 2x price change = 5.7% loss
  • 3x price change = 13.4% loss
  • 5x price change = 25.5% loss

This meant that in September 2020, the SUSHI-WETH pool on SushiSwap incurred massive impermanent losses. This abuse occurred when the price of SUSHI was crashing by over 80%. Just remember that this example assumes the original SushiSwap. Yet the mechanics of impermanent loss apply to any liquidity pool—even one on SushiSwap v3. Research studies on Uniswap V3 show that at least half of users experience negative returns from impermanent loss. For some of these pools, these losses can exceed trading fee profits by 70-75%, informing third-party researchers with wild west risks prevalent on such platforms.

SushiSwap v3: Concentrated Liquidity and Active Management

SushiSwap v3 gives LPs the ability to use concentrated liquidity, meaning they can provide liquidity within predetermined price ranges. By focusing their liquidity, LPs are able to earn more fees with less capital at risk. An LP that actively manages their range can make significantly more than a passive yield farmer. By essentially parking a much smaller amount of capital across a wider band, they can use price stability to turbocharge their profits.

This added capital efficiency comes with added complexity and risk. Active range management is crucial. Once the price moves beyond this range, the LP will no longer earn trading fees. This uniquely exposes them to impermanent loss risk.

Active range management increases returns for liquidity providers. It allows them to focus on narrower price bands, improving their capital efficiency. However, active management comes with additional costs, such as gas fees for adjusting liquidity ranges, which can "burn through several hundred dollars a month." From the perspective of potential liquidity providers, the need for active management could be perceived as a disadvantage. More importantly, it requires huge investments of time and creative energy to proactively control their liquidity bands.

Strategies to Mitigate Impermanent Loss on SushiSwap v3

Here are some options:

  • Stablecoin pools: Using stablecoin pools, such as USDC/USDT, can minimize impermanent loss as they are less affected by market volatility compared to pools with highly fluctuating assets.
  • Diversification: Providing liquidity to pools with assets that have a stable price ratio can reduce impermanent loss.
  • Monitoring pool imbalance: Keeping an eye on pool imbalances, such as a whale leaving the pool, can help LPs adjust their strategies to minimize impermanent loss.
  • Adjusting liquidity provision: LPs can adjust their liquidity provision to maintain a more balanced exposure to assets in the pool.
  • Focusing on fee generation: LPs can focus on generating fees through trading volume to offset impermanent loss.

These strategies need a lot of hands-on monitoring and rebalancing, which fits in with the active management side of SushiSwap v3.

Is SushiSwap v3 Right for You?

SushiSwap v3 offers an extremely attractive opportunity for LPs who are looking for better returns. It’s not a “build it and they will come” investment. These two factors, active management and risk of impermanent loss, call for real care and discretion.

Before embarking on the journey with SushiSwap v3, consider your risk appetite and investment horizon. If you are comfortable actively managing your liquidity positions and understand the risks involved, the potential rewards can be significant. If you’re looking to take the backseat, look to DeFi strategies with a lower risk profile. ThrowingToken.com urges readers to do their own due diligence and understand how DeFi platforms such as SushiSwap v3 work before putting any capital into it.