Risks associated with liquidity provision

Impermanent Loss

This is when the total dollar value of the deposited tokens is at a loss from liquidity provision compared to just holding, as the price of the assets in the pool changes. In simple terms, Impermanent Loss means that the fiat value of a user’s crypto assets deposited to a pool could decline over time. Tokens might lose value or diverge in price based on supply and demand. When this happens it usually creates an imbalance in liquidity, resulting in an uneven and lower reward, also called impermanent loss. This phenomenon is called impermanent loss because AMMs work with the premise that tokens will return to their original divergence, leaving you with the profit of trading fees. However, this is not always the case, especially with highly volatile tokens in which profits turn into permanent losses. Since impermanent loss happens because of volatility in a trading pair, pools featuring at least one stable asset (an asset whose value is pegged to a fiat currency, most commonly to the USD, such as Dai, USDC or USDT), as is the case with the USDC-ClAY pool, are less vulnerable to impermanent loss. Despite the risk, it is important to note that liquidity provision is often still profitable despite impermanent loss — offset by the pool rewards received, depending on the trading volumes.

Smart Contract Vulnerabilities

Liquidity pools are built on smart contracts that perform market-making. However, mistakes in code can create backdoors that can lead to exploits. In order to minimise this risk, Sumero has commissioned smart contract audits on the codebase which can be seen here (hyperlink). However, there are always risks of there being hidden/unidentified bugs, as is the case in any software application/code.

Loss or Theft

If you lose your LP token, then you lose your share of the liquidity pool and any interest gained.

Liquidation of Synth Position

In instances where an open synth position is not being correctly collateralized, the position will be partially or fully liquidated. The position holder will lose some or all of their original collateral deposit.

Malfunctioning Liquidation Bots

Liquidation bots may malfunction and fail to liquidate a position. This would put other synth position holders' ability to withdraw collateral at risk as the market isn't functioning as it is supposed to.

Lack of Users to Propose Liquidations

The Sumero protocol may not have enough active users to propose liquidations for positions that meet the liquidation criteria. This would put other synth position holders' ability to withdraw collateral at risk as the market isn't functioning as it is supposed to.

Development of Illiquid Synthetic Asset Markets

Assets that cannot be easily bought or sold are defined as illiquid. Synthetic asset markets can become illiquid if there is a lack of sufficient liquidity provided to the protocol by liquidity providers. If the liquidity of an asset pair starts to dwindle, withdrawals and/or borrows that surpass the available amount of liquidity will fail. While Sumero's incentivization mechanism attempt to hedge against the risk of illiquidity and voided withdrawals, the possibility of illiquidity arising in the system cannot be ignored. The liquidity of each USDC-synth pair ultimately depends on whether or not liquidity providers are comfortable providing liquidity to the protocol in return for the rewards offered.

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