Impermanent loss in crypto occurs when you provide liquidity to a given pool and your assets’ value fluctuates.
Related: Future of Cryptocurrency in 2023 and beyond
You have probably heard of the phrase “impermanent loss in crypto” if you use the decentralized finance (DeFi) ecosystem. To reduce investment risks, it is crucial for anybody involved in DeFi to understand this idea. How can you avoid impermanent loss in crypto and what precisely is it?
In DeFi protocols, there is a danger of impermanent loss when providing liquidity to multi-asset liquidity pools. By offering assets (liquidity) for traders to trade across assets, users of these pools can get paid. Although lending money to a liquidity pool might be quite profitable, it’s vital to consider the chance of impermanent loss in crypto.
When the value of your tokens declines from the time you put them in the pool, this is known as an impermanent loss in crypto. The loss grows in proportion to the size of the change. It originates from a fundamental characteristic of a unique kind of market called an automated market maker. It can be profitable to lend money to a liquidity pool, but you must keep in mind the idea of impermanent loss in crypto.
Introduction
Volume and liquidity for DeFi protocols like Uniswap, SushiSwap, and PancakeSwap have skyrocketed. With the help of these liquidity protocols, practically anyone with money can act as a market maker and generate trading commissions. The crypto industry has experienced a lot of frictionless economic activity due to the democratization of market making.
Understanding impermanent loss in crypto is necessary if you want to provide liquidity for these platforms.
What is impermanent loss in crypto?
When the value of your tokens declines from the value they had when you deposited them in the liquidity pool, this is known as an impermanent loss in crypto. It all comes down to the automated market maker (AMM) mechanism, a decentralized exchange that pools user liquidity and uses algorithms to price the assets in this pool.
So, impermanent loss happens when the price of the assets in the pool changes.
— Binance (@binance) February 16, 2021
But how much is it exactly?
Learn more here ⬇️https://t.co/SqNETEubFA
The simplest way to describe an impermanent loss in crypto is when you put assets into a pool and incur a loss when you withdraw them later as opposed to simply holding these assets throughout this time. Therefore, a temporary loss might happen even though no money is really lost. Instead, it’s possible that you’ll only see marginally lower profits than you would have with a purchase-and-hold approach. Understanding impermanent loss in crypto is greatly improved by looking at an example with some numbers.
Assume you are a liquidity provider (LP) and you choose to add liquidity to a pool that is split 50:50 between YLD and USDT. This implies that you must give the pool both tokens with an identical value.
As you can clearly see, the value of both tokens, expressed in US dollars (or any base currency), is the same at the time of deposit.
YLD is worth $0.30 when the assets are deposited. But suppose YLD’s price on an outside exchange rises to $0.35. Arbitrage traders have a chance to profit from the difference between the value of YLD in your liquidity pool and that of an external exchange. By acquiring the less expensive YLD from the liquidity pool and selling it for more money on the open market, they can profit.
The AMM is made to maintain a steady percentage of tokens in the pool. Therefore, as the YLD is being purchased, its value relative to USDT will rise. The amount of YLD in your asset pair will consequently decrease to preserve balance, while the number of USDT will increase until a new equilibrium is established where the value of your YLD once again equals the value of your USDT.
We computed the amount of impermanent loss that would happen in our case using this helpful impermanent loss calculator from Daily DeFi (see table). This calculator can also be used to calculate the temporary loss on assets with different valuations.
What makes it an impermanent loss in crypto, then? The loss, however, only exists at this point in digital form or on paper. If the LP chooses to remove its liquidity from the pool at this price, the loss will be realized and become irreversible. The loss won’t be realized, though, if they wait and the price lowers back to $0.30.
Keep in mind that price changes in either way can result in impermanent loss. In the scenario above, temporary loss would also occur if YLD dropped below $0.30. Therefore, in a dual asset pool, the only method to entirely prevent impermanent loss is to withdraw your digital assets at the exact same price that they were deposited.
How to calculate the impermanent loss in crypto?
You can calculate the impermanent loss in crypto by using this formula:
The term “variable k” in this formula denotes the ratio of change from the initial to the future price. For instance, k would be worth 1.1 if an asset increased by 10%.
You can multiply the percentage by the original value once you know the value of the temporary loss for the specified change k in order to determine the actual dollar amount.
For instance, if my asset’s initial purchase price was $1,000 and my impermanent loss was 0.6%, the actual impermanent loss to the liquidity pool would be $1,000 * 0.6%, or $6.
So why would one use a liquidity pool?
If one of the assets has considerable price swings, the value of the temporary loss may be extremely high. According to the chart below, the impermanent loss would be 25% if an asset in the pool saw a 500% increase in value. As a result, it can appear that taking part in liquidity pools is not worthwhile.
However, LPs are able to get a share of the trading fees from each deal that passes through a liquidity pool, which is a benefit of liquidity pools. Your portion of the liquidity pool is taken into account when distributing the trading fee payment. This approach can still be more profitable than merely retaining the assets even when a temporary loss occurs because of the earnings from providing liquidity.
LPs are also given additional incentives by several liquidity pools. The practice of “yield farming,” also known as “liquidity mining,” compensates LPs for supplying liquidity with fresh tokens, whose worth may even be more than the temporary loss. Since buying and holding is less profitable, liquidity mining may be a better option.
You should never put any assets into a liquidity pool that you cannot afford to lose since liquidity mining is a strategy that should only be used by knowledgeable investors in digital assets who are aware of the risks.
How to avoid impermanent loss in crypto?
Trading commissions can frequently be used to cover temporary losses, and token incentives can produce larger total returns than a buy-and-hold strategy would have. But there are other ways to lessen or even completely minimize the risk of transitory loss.
Low volatility pairs
The danger of an impermanent loss in crypto is automatically decreased by selecting asset combinations with lower volatility because there is less chance that one or both assets may experience a big change in value. This might include stablecoin pairs like USDT and DAI. The larger profits, though, may make more volatile pools remain appealing.
Numerous varieties of liquidity pools
It’s not necessary to contribute assets to liquidity pools in a 50:50 ratio in all cases. The danger of temporary loss might be reduced by considering a different kind of liquidity pool. It is necessary to have prior knowledge and a solid grasp of DeFi because these pools are more complicated.
Some decentralized exchanges, for instance, provide a range of liquidity pool percentages. For instance, a pool with an 80:20 ratio (where 20% is the ratio of the more volatile asset) would expose an LP to a lower risk of impermanent loss than one with a 50:50 ratio. Additionally, multi-digital asset complex liquidity pools are readily available. Additionally, some exchanges have created liquidity pools in which only one asset can be staked; the platform’s native token is present on the other side of the pool.
Users should proceed with the utmost caution while playing with these kinds of pools, though, as they are complicated financial products that are unsuitable for inexperienced investors. Users may encounter extra threats that weren’t previously thought of as the industry standard for these is still being developed.
Passive income
You can see that liquidity mining can be difficult and time-consuming, and it exposes you to dangers like a temporary loss. You may reduce these risks while generating a solid, consistent income by holding most of your digital assets in a passive income plan. Platforms for managing your digital assets’ wealth, such as YIELD App, provide protection and safety for your assets while offering annual interest rates on stablecoins (USDT and USDC) of up to 18%.
Conclusion
Mining for liquidity has the potential to pay out handsomely. High rewards come with greater risks, though. As a result, inexperienced cryptocurrency investors should consider their decisions carefully before contributing liquidity to a pool to reduce the danger of temporary loss. Even seasoned bitcoin investors should constantly be aware of the possibility of temporary loss and make sure they have a portfolio structure in place that allows them to reduce this risk, such as passive income.
More to read:
Follow Crypto Stoshi: Twitter, Telegram
Disclaimer: This blog is for educational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.
