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Understanding Impermanent Loss in Cryptocurrency

Impermanent loss is one of the inevitable experiences in cryptocurrency. This loss in crypto investment is not permanent and can affect all the parties involved.

Impermanent loss is common to liquidity providers when they deposit tokens into a liquidity pool. It takes a special kind of scrutiny to understand impermanent loss and how to determine how much is actually lost.

In this post, we’ll discuss what impermanent loss meant in cryptocurrency. Before then, let’s learn about the concept of impermanent loss which includes liquidity pool and automated market marker (AMM).

What is a Liquidity Pool?

A liquidity pool is a digital pile of cryptocurrency locked in a smart contract. This results in creating liquidity for faster transactions.

Liquidity pools are designed to incentivize users of different crypto platforms, called liquidity providers (LPs). After a certain amount of time, LPs are rewarded with a fraction of fees and incentives, equivalent to the amount of liquidity they supplied, called liquidity provider tokens (LPTs). LP tokens can then be used in different ways on a Defi network.

The liquidity pool aims to eliminate the issues of illiquid markets by giving incentives to its users and providing liquidity for a share of trading fees.

Trades with liquidity pool programs like Uniswap don’t require matching the expected price and the executed price. It is important to note that significant financial institutions do not participate in liquidity pools due to the risk of a temporary loss of Defi.

Liquidity pools are also essential for yield farming and blockchain-based online games. A major component of liquidity is the automated market marker (AMM).

What is Automated Market Marker (AMM)?

Automated market marker (AMM) is a protocol that uses liquidity pools to allow digital assets to be traded in an automated way rather than through a traditional market of buyers and sellers.

Users of an AMM platform supply liquidity pools with tokens and the price of the tokens in the pool is determined by a mathematical formula of the AMM itself.

AMM makes trades on DEX markets easy and reliable. They are programmed to facilitate trades efficiently by eliminating the gap between the buyers and sellers of crypto tokens.

Understanding Impermanent Loss in Cryptocurrency

There are multiple ways for a liquidity provider to earn rewards for providing liquidity with LP tokens, including yield farming. However, an impermanent loss is one of the things you would experience when you aim to collect high returns for a slightly higher risk.

Impermanent loss happens when the price of your assets locked up in a liquidity pool changes. This creates an unrealized loss, versus if you had simply held the assets in your wallet.

In this case, a DEX allows any token holder to deposit their tokens into a liquidity pool. The token pair is usually Ethereum-based and a stablecoin like USDC. A transaction fee of 0.3%. will be paid to the liquidity providers.

A trader can therefore swap let’s say ETH for USDC in a liquidity pool. It has to be the equivalent amount of the token-a liquidity pool must contain a 50/50 ratio in the value of both tokens.

So, if you are staking 1 ETH, you need to put in the equivalent 100 USDC as well. Then, if the entire pool contains 10 ETH and 1000 USDC after your deposit, your total share is 10%.

The 10% of the total transaction fees (0.3%) made up to that point is what you’d earn if you decide to withdraw. If ETH’s price remains the same, and there had been 100 ETH worth of trade volumes before your withdrawal. This would result in a 0.3 ETH earning for the liquid providers.

As stated earlier, the pair involved must be equal. So 0.3 ETH translates to 0.15 ETH and 15 USDC. The liquidity pool now has 10.15 ETH and 1,015 USDC. With a 10% share at this point, you’ve made a profit.

How Does Impermanent Loss Occur?

Volatility is the major issue with cryptocurrency as prices can fall or rise at any time. The issue of volatility is what everyone involved in liquidity pools will face which will lead to impermanent loss.

Impermanent loss happens when the price of your token changes after you deposit it in the liquidity pool.

As discussed earlier, if the price of ETH goes up to $250, you’ll now be looking at a 1 ETH per 250 USDC exchange rate.

At this point, you’ll realize had you held on to your 1 ETH and 100 USDC, you would have had $300, meaning $100 in profit. But since you’ve deposited it into the liquidity pool, you’re stuck with the original price, resulting in a 50% impermanent loss.

The loss incurred in this form is however for a moment-it is impermanent. If the Ethereum-based token later goes back down to the original price at your deposit, then you break even. Your loss is however permanent when you decide to withdraw after a price change.

How to Avoid Impermanent Loss in Cryptocurrency

Although impermanent loss is inevitable. However, there are measures that can be taken to mitigate this risk. They are discussed below,

1. Choose Stablecoin Pair that Offer the best

One strategy to avoid temporary loss is to choose stablecoin pairs that offer the best bet against impermanent loss. This is because their value does not move much. They also have fewer arbitrage opportunities, lowering the risks. Liquidity providers using stablecoin pairs, on the other hand, are unable to gain from the bullish crypto market.

2. Choose Pairs that do not expose liquidity to market stability

You need to choose tokens (ETH base & stablecoin pair) that do not expose liquidity to market stability. Cryptos with an unstable history or high volatility should not be considered. Another strategy to avoid temporary loss is to search the market, which is highly volatile thoroughly.

3. Timing

Liquidity providers must also know when to sell their holdings before the price drifts too far from the starting rates. This would help to curtail the effect of a change in price.

4. Look beyond the loss

One of the best ways to overcome impermanent loss is to look beyond it. The tokens you’ve committed already have a purpose, which is to earn you trading fees. Let them do their job for the more you put into the equation.

Conclusion

Impermanent loss is an inevitable experience for those involved in liquidity pools. The main cause of this loss is volatility as it is with other crypto endeavors. Impermanent loss is based on sheet value, meaning it can keep changing until an action is taken.

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