What is Impermanent Loss and How to Avoid It?

Published on: 22.11.2022
What is Impermanent Loss and How to Avoid It?

Investment strategies like yield farming, in which tokens are lent out in exchange for interest and prizes, are sometimes accompanied by the risk of impermanent loss.

It sounds like staking, but there’s more to it than that. Liquidity provision, or borrowing your tokens to a liquidity pool, is at the heart of yield farming.

What Is Impermanent Loss?

Liquidity providers occasionally suffer a temporary loss of funds due to fluctuations in a trading pair, referred to as an “impermanent loss.” It also shows how much wealth a person may have amassed had they not provided liquidity. While one asset in a liquidity pool could be a stablecoin like DAI, the other might be a more unstable cryptocurrency like ETH.

Imagine a scenario where a vendor needs to maintain the same level of DAI and ETH liquidity but the pricing of ETH spikes. Since the value of ETH inside the liquidity pool no longer reflects market conditions, arbitrage becomes a tempting opportunity. As a result, other dealers will purchase ETH at a subsidized cost until the DAI/ETH ratio is stable.

For instance, the volatility of a DAI/ETH liquidity pool is lower than that of an ETH/SUSHI pairing. Due to having DAI as a stable commodity to swap with.

This decline is temporary as prices eventually settle back to their original exchange rate. If the current market value of your asset is equal to the initial deposit value, you will incur no impermanent loss. You finalize the loss if you pull money out of the liquidity pool.

It is easy to understand why the market price on a marketplace like Coinbase is unique from the value in a liquidity pool, but why is that? The automated market maker mechanism used by liquidity pools sets them apart from traditional exchanges.

How Does Impermanent Loss Happen?

In a perfect world where pricing is a tranquil candlestick, we now understand how liquidity companies make money. But, unfortunately, price fluctuations are par for the course in the world of cryptocurrencies. When you deposit your tokens into the liquidity pool and their value decreases afterward, you experience an impermanent loss.

Continuing with the previous case, if the cost of ETH increases to $200, the corresponding exchange rate in DAI would be 1 ETH for 200 DAI. That’s a $100 profit from what you could have spent with $300. However, you can’t withdraw it from the liquidity pool without paying the original price, which means you’ve effectively lost 50% of its value.

The silver lining is that this may be a momentary setback. If the price of ether drops to the level it was at the time of your deposit; you will have broken even. Because a liquidity provider receives the liquidity pool’s tokens instantly upon committing or depositing funds to a pool through a smart contract, their participation in the pool is also significant.

The tokens are for liquidity provider to withdraw their stake from the pool whenever they like. So, is it possible to sustain monetary damage from temporary setbacks?

Here is when the concept of IL comes into play. Because they are only guaranteed a percentage of the total token supply rather than a set number, liquidity providers are exposed to an additional risk known as IL. That’s why it happens if the worth of your deposits goes up or down from when you initially made the deposit.

Remember that the liquidity provider’s exposure to IL increases in proportion to the size of the change. The loss occurs because the amount withdrawn is less than originally deposited. A complete recovery in cryptocurrency prices would negate this impermanent loss. Furthermore, the vulnerability to transient loss is entirely covered by the trading fees received by liquidity providers.

How To Avoid Impermanent Loss?

Having a firm handle on the nature of impermanent loss, we can move on to considering how to lessen our vulnerability to it.

✅Find stable coin pairs first. There is no chance of short-term loss while providing liquidity for a pair like USDC/USDT since the prices are stable, as the name says. In a down market, you can still make money by collecting your fair portion of trading fees with this tactic.

✅Dividing your cryptocurrency holdings in half can protect you from impermanent loss. Only one piece should be put into the liquidity pot. Half of the loss will be temporary, and the other half can be held indefinitely. Since just half of your funds are participating in the pool, any costs or benefits you receive will be cut in half, too.

✅Take the ETH/DAI pair as an illustration of a possible scenario. There will be an impermanent loss of 2.18% if the value of ETH rises by 50%. A loss of $20 on a $1000 investment is a minor and temporary setback. Your impermanent loss, however, will reduce to US$10.1 if you only put half of your DAI and ETH pairing into the liquidity pool.

✅When trading cryptocurrencies, it’s best to steer clear of the more unstable pairs. Instead, you should opt for more stable pairings if your analysis shows that one asset in a pair will surpass the other.

✅Keep an eye out for cryptocurrency pairs where the prices appear to climb and fall in lockstep. You should think this choice over carefully and conduct appropriate study and analysis. You might also expand your search for LPs beyond the standard 50/50 split and look for partners with unequal asset ratios.

For example, pool asset distributions for services like Balancer might vary from 95:5 to 80:20 to 60:40. Figure out what helps you.

✅Last but not least, even if you risk an impermanent loss, certain liquidity pools provide incentives to offset any losses that can occur due to a shift in price. Your portion of the trading fees may more than cancel out any impermanent loss on paper if they are substantial.

Final Thoughts

The concept of impermanent loss in a liquidity pool is crucial to understanding decentralized finance and, more specifically, yield farming. Realizing the meaning of impermanent loss illuminates the lost opportunities associated with choosing to hold assets rather than offer liquidity.

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