What is impermanent loss?
If you are familiar with Defi, you’ve almost heard about impermanent loss . Liquidity protocols allow any person with funds to become a market maker and earn trading costs. The democratization of the market economy has enabled many economic activities without friction in the cryptographic space. The advent of decentralized finance (DeFi) has created opportunities for cryptocurrency investors to earn interest on their holdings.
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With the decentralization of traditional financial services, anyone can now provide funding to Defi applications. The deposit of digital assets, often in standard liquidity pools, can generate interest rates significantly higher than what is currently available from global banks. Decentralized exchanges use an automated market maker, which allows anyone holding tokens to deposit their tokens into a liquidity pool.
Where a fund has sufficient liquidity, investors may deposit an equal amount of each asset in their digital wallet. In this case, the investor is likely to receive liquidity provider tokens. This is a summary of your deposits in the form of a given percentage of the liquidity pool. In general, it is dynamic and corresponds to the liquidity flexibility the investor offers about the total amount present in the pool. For all investors, it is essential to know the risks associated with decentralized finance, better known as Defi. One of the significant risks associated with managing decentralized finance is impermanent loss. So what you need to know if you would like to provide liquidity for those platforms?
How to calculate impermanent loss
Impermanent loss occurs when you provide liquidity to a liquidity pool, and the price of your deposited assets changes from what you have deposited them. The greater the change, the greater the exposure to impermanent loss. In this case, the loss is lower than the dollar value at the time of withdrawal compared to the time of filing. It happens when they are deposited in an automated market maker (AMM), and removing them later causes a loss, compared to whether you left it in your wallet or not. You can’t lose money, but your earnings are less than if you had just left your assets intact. The volatility factor may be an investment risk if the digital currency is deposited into an AMM or Defi pool.
In a liquidity pool, the make-up of tokens is regulated by an algorithmic formula that balances the ratio of tokens in the pool. As AMM formulas prioritize balancing the ratios of the tokens in the pool, your asset value could differ from its value outside the pool, leaving you at a loss. When there is significant divergence, the severity of impermanent loss also increases, affecting the crypto portfolio of a liquidity provider. The number of liquidity providers and tokens in the liquidity pool defines the risk level of impermanent loss.
This is not an actual loss because the loss is based on the value of your investment if the tokens were held outside of the liquidity pool. Therefore, if you measure your cash investment, the temporary loss may not result in losing money. Liquidity pools often have two assets, and if one can be a stable currency like DAI, the other can be a more volatile cryptocurrency like ETH. The loss is only permanent if a provider withdraws their liquidity for good.
Why be a liquidity provider?
Investors are always prepared to deposit their cryptocurrencies into a DeFi pool despite the odds of impermanent loss. Liquidity providers can compensate for the loss through the collection of transaction fees. Trading costs fluctuate between different crypto trading exchanges, making crypto liquidity pools profitable even though they have the risk of impermanent loss. Trading charges refer to a specific amount a person must pay when purchasing or selling cryptocurrency. While making such a transaction, a wide range of percentages or rates is added to the basic fees. If your yield generates higher returns than the amount you lose from impermanent loss, you can get more profit than just holding the tokens.
Furthermore, by receiving a yield on your tokens in a liquidity pool, you also transform them into productive assets. In many cases, earned expenses could easily undo losses. Thus, investment in a liquidity pool could always be profitable even if the value of the cryptocurrency changes.
How can we avoid impermanent loss?
Price switching called impermanent loss because prices may revert to the original exchange price in the future. The impermanent loss reverse if your asset assessed at the same price as the original deposit. The loss only becomes permanent if you withdraw your money from the liquidity pool. How do you prevent impermanent losses? Liquidity providers are unable to avoid impermanent loss altogether. But there are things they can do to mitigate that risk. Some liquidity pools are at a much higher risk of impermanent loss than others. Generally, the more volatile the fund’s assets, the more likely you will experience impermanent loss. Alternatively, it may be best to start with a small deposit.
This way, you can get an approximate estimate of your expected returns before committing more money. However, they may use specific measures to reduce this risk, such as using stablecoin pairs and avoiding volatile pairs. It is crucial to ensure that these cryptocurrency pairs track roughly the same price. It is essential for ensuring and recording price movements among the given cryptocurrency pair. In addition, you can prevent the temporary loss in a more significant measure if the price volatility of a particular cryptocurrency does not exist at the outset.
Consequently, keeping cryptocurrency peers low volatility is a potential key for little or no impermanent loss. The extent of impermanent loss may also be estimated. Taking into account the unpredictable nature of the impermanent loss and its intensity can also be estimated. Support investors in dealing with the complexity of impermanent losses. Several online calculators can help an investor identify the potential risks associated with depositing assets in a specific liquidity pool.
Despite the risk, liquidity providers remain prepared to put down their assets to the extent that it is possible to compensate for such a loss (in whole or part) by charging a fee. The fee is generally paid through decentralized exchanges. The loss becomes permanent only if a provider withdraws its liquid assets permanently. However, they can use measures to mitigate this risk, such as using stablecoin pairs and avoiding volatility.