Every investor is aware of the risks posed by decentralised financing also known as DeFi. One such serious risk of dealing with decentralised money is impermanent loss.
In this article, we’ll understand about crypto liquidity pools’ impermanent loss.What it means and how to avoid it.
Impermanent loss in yield farming
Crypto liquidity pools’ impermanent loss is when the price of a token rises or falls after depositing it in a liquidity pool.
Yield farming is directly related to impermanent loss. Yield farming is when you lend your tokens to gain rewards. But it is different from staking, as investors are needed to put money into the blockchain for validating transactions and blocking for earning staking rewards.
Contrarily, yield farming entails lending your tokens to provide liquidity or liquidity pools. The rewards depend on the protocol. While yield farming is more profitable than holding, it offers liquidity with liquidation, control, and price risks.
The risk level of impermanent loss depends on the number of liquidity providers and tokens in the liquidity pool. Tokens are coupled with another token, mostly a stable coin like Ether and Tether (USDT).
This way, pools with stablecoins within a narrow price range are less prone to temporary loss. Resultantly, those holding stablecoins face less impermanent loss.
Impermanent loss protection
Impermanent loss protection refers to a type of insurance that tends to protect liquidity providers from unexpected losses.
Liquidity provisioning is only profitable on typical Automated Market Makers (AMMs)if the benefits of farming exceed the cost of temporary loss. But, if the liquidity providers suffer losses, they can use Interledger Protocol (ILP) to protect themselves against Impermanent loss.
For activating ILP, tokens need to be staked on a farm. Let’s take the example of the Bancor Network to understand how ILP works. When a user creates a new deposit, the insurance coverage provided by Bancor grows at a rate of 1% per day, where the stake is active, finally reaching full range after 100 days.
Any temporary loss faced during the first 100 days or any time after that is covered at the time of withdrawal by the protocol. But only partial Impermanent Loss compensation is available for withdrawals made before the 100-day maturity.
For example, after 40 days in the pool, withdrawals receive a 40% compensation for any temporary loss.
There is no Impermanent Loss compensation for all the stakes withdrawn within the first 20 days; the Liquidity pool is liable to the same Impermanent Loss they would have incurred in a conventional AMM.
How does impermanent loss happen?
The main difference between LP tokens’ value and the underlying tokens’ theoretical value if they hadn’t been paired leads to IL.
Let’s take an example of how this works.
Suppose a liquidity provider with 10 ETH wants to offer liquidity to a 50/50 ETH/USDT pool. For this, they would deposit 10 ETH and 10000 USDT in this case (e.g., 1 ETH=1,000USDT)
If the pool has a total asset value of 100,000 USDT (that is 50 ETH and 50,000 USDT), their share will be equivalent to 20% by using a simple equation:
20,000USDT/100,000 USDT) *100=20%
The total percentage of a liquidity provider’s participation in a pool is significant as when a liquidity provider commits or deposits their asses to a pool by a smart contract, they will instantly receive the liquidity pool’s tokens.
So, can you lose money with an impermanent loss?
There is where the idea of Impermanent loss enters the scenario. Liquidity providers are prone to another layer of risk called IL, as they are entitled to a share of the pool rather than a definite quantity of tokens. It happens when the value of your deposited assets changes from when you deposited them.
It is to be noted that the larger the change is, the more Impermanent loss the Liquidity provider will be exposed to. The loss there is referred to the fact that the dollar value of the withdrawal is lower than the dollar value of the deposit.
The loss is impermanent as no loss happens if the cryptocurrencies can return to the price. Also, liquidity providers receive 100% of the trading fees that offset the risk exposure to impermanent loss.
How to calculate the impermanent loss?
If the price of 1 ETH is 1,000 USDT at the time, you deposit but suppose the price multiplies by double and 1 ETH starts trading at 2,000 USDT. An algorithm adjusts the pool and uses a formula to manage assets.
The most popular formula is the Constant product formula:
ETH Liquidity*token liquidity=Constant product
The difference in how AMMs manage asset ratios is known as Impermanent loss.
How to avoid impermanent loss?
Liquidity providers are unable to avoid impermanent loss completely. But they can use some ways to avoid or reduce the risk, like using stable coin pairs and avoiding volatile pairs.
One of the ways to avoid temporary loss is to select stable coin pairs that offer the best bet against IL as their value doesn’t move much; they also have fewer arbitrage opportunities there, decreasing the risks. On the other hand, liquidity providers that use stable coin pairs cannot gain from the bullish crypto market.
You need to Choose pairs that do not expose liquidity to market instability and temporary loss rather than cryptos with an unstable history or high volatility.
Another strategy to avoid temporary loss is to search the market, which is highly volatile, thoroughly. Resultantly, the deposited assets are expected to fluctuate in value.
On the other hand, liquidity providers should know when to sell their holdings before the price drifts too far from the initial rates.
Therefore, many financial institutions don’t participate in liquidity pools due to the risk of a temporary loss of DeFi. But, if individuals and enterprises around the globe widely adopt AMMs, this problem can be solved.
Impermanent loss is a loss that happens when funds are exposed to when they are in a liquidity pool. This loss typically happens when the ratio of the tokens in the LP becomes uneven.
The loss is usually calculated by comparing the value of the tokens in the liquidity pool versus the value of simply holding them. As stablecoins have price stability, LPs that use stablecoins can be less exposed to IL.