AllianceBlock DEX Testnet tackles issue of impermanent loss reduction

In line with its mission to bridge the gap between decentralised and traditional finance, AllianceBlock recently deployed its DEX Testnet on renowned blockchains Polygon and Energy Web Chain.

Coin Rivet spoke with Houman Falakshahi – head of research at AllianceBlock – who confirmed that, during the past few months, AllianceBlock’s research and quantitative analytics team have worked on innovative methods to tackle the issue of impermanent loss reduction.

He explained that the inspiration for AllianceBlock DEX came from physics, “more precisely from coupled systems where energy is transferred from one system to another – we combined two different automated market makers”.

Falakshahi added this has shown the coupled system of AMMs is now able to absorb the impermanent loss of one another and, therefore, optimise the impermanent loss profile.

“We hope this can positively contribute to the research in the field and open new possibilities for future improvements,” he said.

When it comes to AllianceBlock DEX’s novel mathematical model, Falakshahi said that up until this point, there had been two main approaches for creating automated market makers (AMMs) – the underlying protocol that powers DEXs.

The first approach, he says, is based on the family of ‘constant function market makers’ (CFMM).

“They link together the reserves of tokens with a deterministic function and if one reserve changes due to a trade, the rest of the reserves should change as well to keep the function constant,” he explained.

“The second type of approach is based upon managing order books, often partially on-chain where the DEX gathers all the buy and sell orders of users and handles the transactions.”

Falakshahi claims the AllianceBlock DEX approach expands upon the first methodology.

“Rather than having one CFMM, it encapsulates internally two CFMMs into one main AMM visible to the end-user,” he said.

“Each trade is then split into two smaller trades and sent to each internal CFMM.

“The split is done such that both the internal CFMMs always have the same spot – they, therefore, remain synchronised.

“As a result, the risk of impermanent loss, the temporary loss of funds occasionally experienced by liquidity providers because of volatility in a trading pair, is reduced.”

He added that for the end-user, the impermanent loss displays a better overall profile than if using one of the internal CFMM individually.

Impermanent loss as a risk

Talking about the risk of losing some liquidity if price changes occur after staking, Falakshahi said “liquidity provisioning comes with a risk which is called impermanent loss (IL)”.

“Putting assets within a DEX allows the Liquidity Provider (LP) to earn trading fees,” he pointed out.

“With that reward, comes the risk of retrieving more of the cheaper assets and less of the more valuable assets when the market moves.

“The losses then become permanent when assets are withdrawn.”

LPs, he adds, need to measure the risk of high spot movement versus the duration of staking within a DEX.

They also need to monitor the risk profile of the DEX of their choice versus the rewards it distributes.

In general, the probability of strong spot movement is very high in the crypto space.

“Therefore, LPs need to be aware of this risk – they can minimise it by choosing the assets they provide within a DEX, choosing protocols that offer a better IL risk profile, choosing a protocol that gives incentives or rewards for cancelling the IL or staking for a sufficiently long time within a DEX to accumulate trading fees in order to mitigate or totally cancel any potential IL,” he added.

AllianceBlock DEX, is the first version of the company’s new exchange protocol with new features that will be added gradually.

Falakshahi confirmed that, for the first version, Alliance DEX focused on reducing the IL by working on the mathematics at the core of the swapping protocol.

“The improvement is symmetrical and independent of the spot movement direction opposite,” he concluded.

“This gives us the possibility of further improving the IL by means of other features in the near future.”