Impermanent Loss Protection

Protocols can adjust fee structures to compensate for projected impermanent loss. This often involves:

• Increasing swap fees for pools experiencing high volatility.
• Directing a portion of protocol revenue or minting new tokens to subsidize LP rewards.
• The goal is to make providing liquidity more profitable than simply holding the assets (HODLing).

Protection often accrues over time, rewarding long-term liquidity. A common model is linear vesting, where:

• Protection starts at 0% and increases to 100% over a set period (e.g., 1-2 years).
• If an LP withdraws early, they receive only a prorated portion of the protection.
• This mechanism aligns incentives, discouraging mercenary capital that flees at the first sign of volatility.

Accurate IL calculation requires a reliable price feed. Systems use oracles (e.g., Chainlink) to determine the fair market value of assets at deposit and withdrawal.

• The protection payout is the difference between the value of the LP's share and the value if they had simply held.
• This ensures settlements are based on objective, manipulation-resistant external data, not the potentially skewed internal pool price.

ILP is not unlimited insurance. Protocols implement safeguards:

• Coverage Caps: Maximum payout per pool or per user, often funded by a treasury or insurance fund.
• Loss Triggers: Protection may only activate above a minimum loss threshold (e.g., 2% IL).
• Asset Whitelists: Protection is frequently limited to major, less volatile asset pairs (e.g., ETH/USDC) to manage risk.

All ILP implementations balance key variables:

• Vesting Period: Time required for full coverage (e.g., 30-100 days).
• Funding Source: Protocol treasury, minted tokens, or swap fees.
• Coverage Scope: Full 100% reimbursement vs. partial subsidy.
• Asset Paid: Native token or the deposited assets. These choices directly impact protocol sustainability and LP incentives.

ILP creates a protocol liability that must be managed. Key risks include:

• Ponzi-like dynamics if funded by token inflation.
• Insolvency risk during severe, prolonged market downturns.
• Moral hazard where LPs ignore risk. Successful implementations require robust fee generation and careful economic design to remain solvent long-term.

ILP is a financial liability on the protocol's balance sheet. It requires the protocol to hold sufficient reserves (often from treasury or fees) to cover potential claims. If claims exceed reserves, the protocol may become insolvent, failing to pay out promised protection. This risk is heightened during extreme market volatility where many LPs might claim simultaneously.

Guaranteed protection can create moral hazard, where LPs are incentivized to provide liquidity to highly volatile or risky pools they would otherwise avoid, knowing losses are covered. This can lead to:

• Inefficient capital allocation away from safer, more sustainable pools.
• Increased systemic risk if the protected pools experience massive divergence.

ILP mechanisms can be exploited. Attackers may:

• Manipulate oracle prices near the claim timestamp to maximize the calculated loss.
• Use flash loans to artificially create price divergence in a pool, trigger a claim, and profit from the protection payout.
• Engage in LP cycling, where they repeatedly deposit and withdraw to claim protection on short-term volatility.

Calculating impermanent loss and protection payouts requires a trusted price feed. This creates oracle risk. If the oracle is manipulated, delayed, or fails, protection payouts can be incorrect. The security of the ILP mechanism is only as strong as the security and decentralization of its price oracle.

ILP must be funded sustainably. Common models and their risks include:

• Protocol Treasury: Drains community-owned funds, potentially impacting future development.
• Trading Fees: Requires high, consistent volume; protection may fail in bear markets.
• Insurance Premiums: Adds complexity; LPs may opt out if premiums are too high. A poorly designed model can lead to protocol insolvency or abandonment of the feature.

ILP adds significant smart contract complexity. The logic for calculating losses, managing claims, and handling payouts increases the codebase size and audit surface. A bug or exploit in the ILP contract could lead to:

• Loss of protector funds.
• Incorrect denial or approval of claims.
• This is an additional risk layer on top of the base AMM contract risks.