Understanding AMM and Impermanent Loss on XRPL: Navigating the New XLS-30 Release
The XLS-30 (AMM) amendment for the XRP Ledger represents a monumental moment for the Ledger at large. At last, users can provide liquidity to their favourite tokens and receive a share of the trading fees.
A single AMM may exist for each pair of assets within the ledger. If an AMM for a specific asset pair is not yet established, anyone can initiate it or contribute to an existing one. Contributors, known as liquidity providers (LPs), are rewarded with “LP Tokens” by the AMM. These tokens grant LPs several privileges, including reclaiming their share of the pool’s assets (including accumulated fees), influencing the AMM fee structure through voting (where votes are weighted by LP Token quantity), and bidding for trading fee discounts. Active and balanced asset exchanges within a pool enable LPs to earn passive income from fees.
Trading Fees: Maximizing LP Income
Trading fees provide passive income for liquidity providers (LPs) in offsetting currency risk and empower them through LP Tokens, allowing a stake in the AMM’s pool assets. LPs have the leverage to vote on trading fees within a 0%-1% range, ensuring the fees remain competitive to prevent trades from bypassing the AMM for better rates elsewhere. The fee structure is democratically managed via AMMVote transactions, with fees recalculated based on weighted averages of the top eight LPs’ votes, promoting an optimal balance that benefits both liquidity providers and traders.
Auction Slots: Strategic Benefits
Unlike any previous Automated Market Makers, the XRP Ledger’s AMM design has an auction slot that a liquidity provider can bid on to get a discount on the trading fee for 24 hours, with the possibility to extend benefits to four additional accounts. Bids must surpass the current holder’s bid to gain the slot, with partial refunds if displaced. The discount equates to 10% of standard fees. This system aims to mitigate liquidity provider losses from arbitrage by aligning AMM prices more swiftly with external market shifts, thus enhancing value retention for liquidity providers.
Understanding and Mitigating Impermanent Loss
Impermanent loss is a critical concept for liquidity providers in an Automated Market Maker (AMM) system. This phenomenon occurs when the market price of tokens deposited in a liquidity pool changes from when they were deposited. The term “impermanent” suggests that the loss is not realized until the liquidity provider decides to withdraw their tokens from the pool. Understanding that significant market price fluctuations can exacerbate impermanent loss is crucial. However, the impact of impermanent loss can be mitigated by collecting trading fees, which can somewhat offset the unrealised losses.
Additionally, it is theorized that the unique functioning of Auction Slots (as aforementioned) can mitigate the impermanent loss even further. For example, as more users arrive at the XRPL and arbitrage competitiveness increases substantially…will bids on Auction Slots become so significant that it can meaningfully compensate liquidity providers? Can impermanent loss be materially mitigated because of this?
Interestingly, in pairs involving less volatile assets, such as stablecoins, the risk of impermanent loss can be minimal to none. This highlights the importance of asset selection in managing the risk associated with providing liquidity in AMM platforms.
For more information about XLS-30 or other XRPL amendments, click here.
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