Impermanent loss explained

Impermanent loss occurs when the price of your tokens changes compared to when you deposited them. It comes as an inherent risk of providing liquidity to an automated market maker (AMM).

While providing liquidity to a token reserve can be a lucrative investment strategy, it can be concerning to know that you could lose money by doing so. This is why it pays to account for impermanent loss as a significant risk and understand how it works so you can better navigate it.

What is impermanent loss?

The DeFi ecosystem is fast-evolving, and it’s partly due to the invention of automated market makers (AMMs). AMMs are tools that facilitate trading without the need for intermediaries.

AMMs allow anyone to become liquidity providers, and in exchange for adding funds to the reserve, liquidity providers earn a fee from transactions on the platform proportional to your stake in the pool. Some pools also offer the incentive to stake your tokens.

But while the rewards can be attractive, liquidity providers have to deal with impermanent loss, which is inevitable when you provide liquidity to a pool. The loss refers to the decrease in the dollar value of your token from the time of deposit to the time of withdrawal. The larger the difference, the bigger the loss.

How does it happen?

This loss commonly occurs in pools that contain highly volatile assets like Bitcoin or Ethereum, or in more dynamic pools that contain more than two tokens at different ratios. That said, higher-priced assets have a bigger risk of impermanent loss.

Conversely, when the pool contains assets with a lower price range, as in stablecoins, liquidity providers are less exposed to impermanent loss.

The loss occurs because the trading price of an asset in a liquidity pool is determined by its ratio to the other assets in the pool. This ratio is the only significant factor that determines the intensity of the relation between the assets.

The loss is impermanent because an investor only realizes the losses once they withdraw their funds from the liquidity pool. It usually happens to investors who pull funds early due to panic-inducing market downswings.

How to avoid impermanent loss

So why do investors still deposit funds to liquidity pools despite knowing the risks, you might ask?

This is because impermanent loss can be counteracted, in most cases, by the trading fees and other rewards earned. Even popular platforms like Uniswap, which are quite exposed to this risk, can still be profitable due to the high trading fees.

That’s 0.3% on every trade that goes directly to liquidity providers. But it’s important to note that the risks and upsides would still depend on the protocol, the deposited assets, the pool, and other external market conditions.

In addition to the transaction fees, there are also other ways to curb the risk of impermanent loss. Some proven strategies include:

  • Investors can provide liquidity in pools where cryptocurrency pairings follow nearly the same price. Low cryptocurrency peer volatility translates to low to zero impermanent loss.

  • Invest in Balancer AMM platforms where liquidity pools have multiple digital assets. Compared to pools with a half split, the price changes in these pools usually have a higher ratio, leaving no room for impermanent loss.

Impermanent loss puts investors at a significant disadvantage, but adding liquidity to a liquidity pool can have many rewards that could easily thwart impermanent loss. This is why it’s important to understand the risks of AMM and DeFi trading so you can make more informed, confident decisions.

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