> For the complete documentation index, see [llms.txt](https://funarchy.gitbook.io/funarchy/llms.txt). Markdown versions of documentation pages are available by appending `.md` to page URLs; this page is available as [Markdown](https://funarchy.gitbook.io/funarchy/security-for-prediction-market/trading-mechanism/amm-risks/permanent-loss.md).
# Permanent Loss
#### Description
Recently, prediction market (PM) platforms have adopted an open model, allowing anyone to freely create markets and provide liquidity.
However, this expanded authority can lead to unexpected financial losses for ordinary users lacking specialized knowledge. Therefore, platforms must clearly disclose the structural risks associated with market creation and liquidity provision in advance through documentation.
Odinary DEX must provide liquidity at a specific ratio when supplying liquidity. However, Prediction Markets allows the protocol to automatically adjust liquidity by supplying Yes/No Shares simply by inserting USDC. However, unlike ordinary DEX that provide liquidity at a specific ratio, if the current market is imbalanced, Prediction Markets will provide not only LP tokens but also other tokens.
The following describes the permanent loss that occurs when providing liquidity in a **Market Creation state,** and the permanent loss that occurs when a typical liquidity provider provides liquidity in **a Equal or Unequal Market**.
#### Market Creation State
{% stepper %}
{% step %}
**Market creation and liquidity provision**
* Situation: User A deposits 1,000 USDC to create a Trump win (YES/NO) market.
* LP Position: 1,000 YES and 1,000 NO are issued using the deposited 1,000 USDC as collateral, and these are placed in the pool to provide liquidity.
* $$Yes(1000) \* No(1000) = 1000^2$$
* Status: Initially balanced with YES 50% : NO 50%.
{% endstep %}
{% step %}
**Trading occurs**
* Situation: As time passes and information and news emerge that Trump is likely to win, User B purchases $1,000 worth of Yes at once.
* AMM Operation: FPMM temporarily provides liquidity to the formula that processes this order.
* But $$1000^2$$ is must not be broken. \
\
So, with the information we know, $$No(2000)$$, and the fixed value $$1000^2$$we can calculate the Yes share that will come out later.
* $$Yes(x) \* No(2000) = 1000^2$$
* $$Yes(x) = 1000^2 / No(2000)$$\
$$Yes(x) = 500$$
* This should leave you with a total of 500 Yes shares for a total of $1000.
* LP Position Change:\
In conclusion, Yes's share was left at 500, so B received a total of 1500.\
\
$$Yes(2000) - Yes(500) = 1500$$\
\
In other words, while the liquidity provider is still "providing liquidity," in reality, **they are heavily betting on the No side, which is more likely to lose.**
* $$Yes(500) \* No(2000) = 1000^2$$
* This changes the Yes/No price ratio from 50:50 ⇒ 80:20.
* User A's loss up to this point can be derived using the following formula.
* $$V(p) = (\text{YES Price}) + (\text{No Price})$$
* $$V(p) = \mathbf{2} \cdot \sqrt{k} \cdot \sqrt{p(1-p)}$$
* *Initial price ratio*: $$V(0.5) \propto \sqrt{0.5 \times 0.5} = \sqrt{0.25} = 0.5$$
* *Price ratio thereafter*: $$V(0.8) \propto \sqrt{0.8 \times 0.2} = \sqrt{0.16} = 0.4$$
* $$Ratio = \frac{V(0.8)}{V(0.5)} = \frac{0.4}{0.5} = 0.8 \quad (80%)$$
* In the end, after the transaction, only $800 is left from $1000.
{% endstep %}
{% step %}
**Market closed and loss confirmed**
* Result: \
The actual election results are confirmed as Trump's victory, so YES wins and NO loses.
* Settlement: \
YES tokens will be worth 1 USDC each, NO tokens will be worth 0 USDC each, A will only recover some of the reduced YES tokens for real value, and all of the large NO tokens will become worthless pieces of paper.
* Conclusion: \
Even though A initially deposited 1,000 USDC, at the time of withdrawal, he will only recover about 500 USDC, resulting in a permanent loss of about 50% of the principal.
* Even if a fee exists as of now, a 3% fee on $1000 is $30, or a loss of $470.
{% endstep %}
{% endstepper %}
A typical liquidity provider provides liquidity to a market in one of two states:
* **Equal market state**
* **Unequal market state**
These two situations are explained as follows:
#### Case 1: Equal market state
{% embed url="" %}
#### Case 2: Unequal market state
{% embed url="" %}
#### Mitigation
* If anyone can create a market and provide liquidity on a PM platform, the platform must disclose and disclose the threat in its Document.
* Polkamarket has [documented](https://help.polkamarkets.com/how-polkamarkets-works/market-liquidity/strategies-and-risks-for-liquidity-providers) the risks of providing liquidity to AMMs.
---
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