Impermanent Loss - A Misunderstood Concept?
Impermanent loss has become the bane but what does it actually mean?
Welcome Anon! Today we are going to talk about a topic that is extremely misunderstood and leads to people getting lost in the yield farming jungle through Liquidity pairs. I will take you through the basics to make you verse enough to avoid the beginner mistakes.
Since DeFi boomed in 2020, providing liquidity to AMM’s such as UniSwap and SushiSwap has been a constant theme. Becoming a liquidity provider opens up new ways to make money for a vast majority that did not have the opportunity before. Who doesn’t like the idea of being able to live on passive income? However, the concept is a fascinating one which has received negative light in the community. To be honest, no one likes losses so that’s fair. In order for you to understand the idea of impermanent loss, you need to understand what a liquidity pool and a liquidity provider are. (If you’re already crypto native and know this, then you can skip this part.)
What is a liquidity pool?
A liquidity pool is a pool of different crypto assets that are locked into a smart contract. They enable everybody to become a market maker and facilitates trading in Decentralized exchanges (DEX) in a permissionless way. For liquidity pools to work to their full functionality you need liquidity providers. The liquidity providers do what it sounds like. They provide liquidity to the liquidity pool and earn a share of the trading fees every time people use the liquidity pool to swap between tokens. The amount of they earn of fees is dependent on the amount of the pool that they own. Also, these pools constantly rebalance themselves and make sure the both assets have the same value. so if you have 10 Bitcoin in the pool worth 30,000 each then the other side of the pool would potentially have USDC worth of 300,000.
Liquidity pools are the backbone of DeFi and solves the liquidity issue that forces people to use high slippage. It has enabled people to bypass Centralized Exchanges (CEX) and trade without order books, since no counterparty needs to hold the exchangeable assets and match peoples orders with each other. Instead of trading peer-to-peer with an order book, you are now trading peer-to-contract through the help of a smart contract.
If you’ve been in crypto for a while you have seen random tokens that have skyrocketed in price but when you try to sell there is no liquidity. On the hand, there have been people that have maximized their slippage and performed swaps and the result are rekt users getting little value for their money. That is the major issue when there are not sufficient liquidity in decentralized trading platforms.
If you don’t know what I am referring to, here is an example of the fees airdrop and somebody losing 850 ETH getting rekt with slippage: https://etherscan.io/tx/0xde78fe4a45109823845dc47c9030aac4c3efd3e5c540e229984d6f7b5eb4ec83
With that said, I mentioned that you can earn trading fees if you are a liquidity provider. This brings us to the main topic of this piece, impermanent loss.
What is impermanent loss?
The simplified version of impermanent loss is: The loss you get from being a liquidity provider instead of holding the tokens in your wallet. How does this occur? When you are a liquidity provider, you want the assets to hopefully have stable price action and not large price changes against each other. This is why it is common practice that one of the two assets in the liquidity pool is a stablecoin. This ensure you do not have large impermanent losses in most cases. A high risk liquidity pool would look something like Ethereum x Dogecoin. Two highly volatile assets that can swing in either direction.
Remember, that liquidity pools constantly rebalances against one another to maintain an equal share of both assets in the pool. So if the Bitcoin previously mentioned increases in price, more Bitcoin will be sold for USDC to maintain the balance of the pool. The ratio between the two assets changes and depending on your share of the pool you might get less value out of the pool when you retrieve it. This is why the incentivization to do this is the yield received for doing this as well, in terms of yield farms.
Nonetheless, people mainly mention impermanent losses in the cases where they have lost more money because of the constant rebalancing. However, it can work to your favor at times as well. If the asset volatile asset which is BTC for instance goes down in value instead. The liquidity pool will automatically rebalance again and “buy the dip” automatically. Thus, averaging down. So even though it limits profits to a degree because of the rebalancing, it also limits losses.
It is usually only talked about in relation to losing money (duh it’s called impermanent loss) when the liquidity pools you enter should be between stable assets to limit this occurring. The more volatile assets you have in your pool the higher risk of impermanent losses which is why these normally rewards you with higher yield as well.
However, if you want to a stable way of accumulating value over time, LPing is a good option if you have properly looked at the pros and cons of doing that. If the yield is lucrative in combination with that, then it’s something worth considering. However, before entering any yield farm requiring LPing you should use a impermanent loss calculator to look at the different options presented to you. You can use it to see the losses received if the coins move or down and calculate it in comparison to the yield received to determine if it’s worth it. The impermanent loss calculator can be found here.
Lastly, if you are a tactical person that wants to get in and out of LP’s at good times, you should get out of the LP when you think that the asset is at “the bottom” of its downwards trend. The best option to do then is to get out of the LP and go for single sided staking at the bottom to maximize your yield (easier said than done). The reason for this would be that you would expect the volatile asset of the pair to reverse and increase in value afterwards.
The same goes for top signals. If you provide liquidity to LP’s that recently had a strong upwards move you risk becoming exit liquidity as people will exchange your asset for stables to take profit. It’s a complicated matter for even the best traders.
What’s your thoughts on impermanent losses? Let me know in the comments below.
I know this can be tricky so I hope this piece was valuable for you. If you liked it, I would appreciate your subscription and feel free to share it with people that it could help. Thank you for taking the time to read this.
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