What is impermanent loss? With the increasing popularity of DeFi platforms, many of you probably have heard of Uniswap and other AMM platforms. The technology has taken off ever since the summer and has become one of the most sought-out platforms. However, there is a fundamental issue that exists with many of these AMM platforms. Users who provide liquidity to AMMs can see their staked tokens lose value for simply holding the tokens. This risk that occurs often in the DeFi space is known as “Impermanent Loss”. This risk has scared a lot of mainstream and institutional investors from providing liquidity. Hopefully this article will allow more users to gain more familiarity with this concept and better allow users to mitigate the risks that exist in the DeFi world.
What is Impermanent Loss? It sounds so complicated!
So, to put it very simply, Impermanent Loss is the difference between holding tokens in AMM and holding them in your wallet. Well okay, when does this occur? The mechanism occurs when the price of tokens inside an AMM diverge in any direction. The greater the divergence, the greater the impermanent loss! Okay…so is there a way for me to get it back? The reason why it is called impermanent loss is because there are some ways for you to get your money back.
One is if the original price of the tokens in the AMM return to their original state when you entered into AMM. The loss will disappear and you will be able to earn 100% of the trading fees. Although, this is an extremely rare case and most of the times these usually become permanent losses that eat up your trade income leaving you only with negative returns.
Okay.. well how can I prevent it from happening to me?
To understand how you can prevent this from happening to you. First, you must understand how AMM pricing works and what arbitrageurs do. AMMs are disconnected from the external markets, meaning if token prices change on external markets, prices will not adjust on AMM. In order for prices to change, it requires an arbitrageur to come and buy the underpriced asset or sell the overpriced asset offered by AMM. And during this process, the arbitrageurs will extract the profits which removes the pockets from liquidity providers resulting in an impermanent loss.
Let’s take a look at an example to better understand this concept:
In the image above, you can see AMM with two assets. If you examine just the price differences you can see that a small change in ETH will cause liquidity providers to suffer impermanent loss.
So a way that you can minimize your losses could be using stablecoins. As many of you may know, pools that hold stablecoins usually attract much more attention as they are less volatile. This reduces the risks of impermanent losses. Another way to minimize the losses can be seen with Balancer that offers pools with arbitrary weights. The standard model is the 50/50 model where users deposit 50% of one asset and 50% of another. However, if a liquidity provider wishes to maintain a high exposure to a certain asset they can join the pool with 80/20 or even 98/2.
This reduces the impact an asset can have depending on the weights in the pool. And lastly, the final way of fighting against impermanent loss is using Bancor V2 pools that adjust their weights automatically according to external prices coming from price oracles. This method helps to mitigate impermanent losses and allows the further adoption of new users into the system! If you wish to learn more about Bancor V2, check out their article here!
Now before you dive into the world of DeFi and start providing liquidity to the pools be sure to DYOD! There are plenty of AMM platforms out there and if you wish to learn more about other AMMs, check out our other articles! Thanks for reading What is Impermanent Loss? Hopefully this article helped you gain better insight towards impermanent losses! If you have any questions, feel free to leave them below!
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