Impermanent loss is a condition of loss of funds or losses that are temporary. which is sometimes experienced by liquidity providers or due to price volatility in the cryptocurrency pairs provided by the Liquidity pool. Liquidity Pools often provide cryptocurrency pairs consisting of two assets, one of which is a stablecoin such as DAI. Others are relatively unstable cryptocurrencies like ETH. The different nature of the two cryptocurrencies causes the risk of an impermanent loss to occur in the liquidity providers.
Why are Impermanent Loss only temporary?
Losses caused by impermanent loss are only temporary. As long as the price returns to its initial price, the losses incurred are only temporary. The loss disappears and we get back 100 percent of the trading fees plus 100 percent of the subsidized reward.
Impact of Impermanent Loss
For liquidity providers, the impermanent loss has an impact on the losses they experience. However, this loss is only temporary. But these losses can become permanent if not managed properly. What often happens is that the price does not return to its original price. So that non-permanent losses become permanent. The condition of the price difference between AMM and the external market provides an opportunity for other parties to carry out an arbitrage strategy, by taking advantage of the price difference.
H
ow to Overcome Loss Due to Impermanent Loss
Actually, the impermanent loss cannot be eliminated. This condition is a risk that must be faced by liquidity providers. However, this risk can be minimized by:
Provides liquidity for stablecoin pairs. Stablecoin pairs such as USDC-USDT have less risk of impermanent loss, so they can be an option in providing liquidity to liquidity pools such as Uniswap. But the downside is that we can’t enjoy profits when the market is bullish. In bearish crypto market conditions providing liquidity for stablecoin pairs provide the advantage of trading fees, on the other hand there is less loss of money due to falling asset prices.
Avoid risky and unstable crypto pairs. If one of the cryptocurrencies of a crypto pair is unstable, you should avoid providing liquidity to that pair. For example, the LINK-ETH pair on Uniswap, if you estimate that one of the components of the crypto pair has the potential to rise higher than the other components, you should not use the crypto pair. Because it can result in frequent impermanent loss. But if the two cryptocurrencies rise and fall relatively the same, the crypto pair can be used because the initial exchange rate will not change much.
Provides liquidity to pools of unequally weighted cryptocurrencies. On uniswap the crypto pair weights used are 50:50. In some other liquidity pools they provide crypto pairs with unequal weights, such as 75% MKR 25% WETH on Balancer.
Provide liquidity to incentivizing pools and participate in liquidity mining programs. To minimize our losses as a liquidity provider, we can participate in a liquidity mining program or become a liquidity provider to an incentive pool. Some pool managers share their tokens with people who provide liquidity to certain pairs in AMM such as Uniswap and Balancer.
Become a liquidity provider on Mooniswap (1 inch Liquidity Protocol). The 1 inch team launched AMM mooniswap which is a competitor to Uniswap. The features they provide can reduce the liquidity provider’s impermanent loss through a different exchange rate approach. One of the features they provide is mooniswap, which is a virtual balance that can reduce arbitrage profits, thereby minimizing liquidity provider losses.
Does not clear liquidity in a pair until the pair’s exchange rate returns to its initial value. Usually, after we provide liquidity to a crypto currency pair, the exchange rate for the crypto pair changes so that we experience losses. This is a natural thing as long as the exchange rate does not deviate too much. After the exchange rate returns to the beginning then we remove the liquidity. However, the cryptocurrency market is highly volatile, so we have to be careful when choosing a cryptocurrency pair.
A non-permanent loss occurs when you provide liquidity to a liquidity pool, and the price of the asset you deposit changes compared to when you deposited it. The bigger this change, the more you face a non-permanent loss.
Bases containing assets that remain within a relatively small price range will be less subject to non-permanent losses. Stablecoins or various wrapped versions of the coin, for example, will remain in a relatively limited price range. In this case, there is less risk of non-permanent loss for the liquidity provider (LP).
So, why do liquidity providers continue to provide liquidity if they are exposed to potential losses? Well, non-permanent losses can still be overcome with trading fees. In fact, even pools on Uniswap that are moderately exposed to non-permanent losses can be profitable thanks to trading fees.
Uniswap charges a 0.3% fee on every trade that goes directly to a liquidity provider. If there is a lot of trading volume going on in a given pool, providing liquidity can be profitable even if the pool is highly exposed to non-permanent losses. This, however, depends on the protocol, the specific pool, the assets held, and broader market conditions.
How can non-permanent losses occur?
Let’s look at an example of how a non-permanent loss might look to a liquidity provider.
Alice deposited 1 ETH and 100 DAI in the liquidity pool. This means the price of ETH is 100 DAI at the time of deposit. This also means that the dollar value of Alice’s deposit is 200 USD at the time of deposit.
Additionally, there is a total of 10 ETH and 1,000 DAI in the pool – funded by other LPs such as Alice. So, Alice owns a 10% share of the pool, and the total liquidity is 10,000.
Suppose the price of ETH increases to 400 DAI. When this happens, the arbitrage trader will add the DAI to the pool and remove ETH from it until the ratio reflects the current price. Remember, AMM does not have an order book. What determines the price of the assets in the pool is the ratio among the assets in the pool. While liquidity remains constant in the pool (10,000), the ratio of assets in it changes.
If ETH is now 400 DAI, the ratio between how much ETH and how much DAI is in the pool has changed. There are now 5 ETH and 2,000 DAI in the pool, thanks to the work of the arbitrage trader.
So, Alice decided to withdraw her funds. As we know earlier, he is entitled to a 10% share of the pool. As a result, he was able to withdraw 0.5 ETH and 200 DAI, for a total of 400 USD. He made a big profit because his token deposit was 200 USD, right? But wait, what would happen if he only held 1 ETH and 100 DAI?
We can see that Alice would be better off with HODLing than depositing into a liquidity pool. This is what we call an impermanent loss. Keep in mind, however, that variable losses can lead to large losses (including large portions of the initial deposit).
Thus, Alice’s example completely ignores the trading fees she would incur to provide liquidity. In many cases, the fees earned will offset the losses and keep the liquidity provision profitable. Even so, it is important to understand non-permanent losses before providing liquidity to the DeFi protocol.