If you are looking to invest in the decentralized finance industry, you must also learn about the risks associated with this investment. One of the biggest risks you have to consider when you invest with the DeFi system is impermanent loss.
In this article, we will take a look at the definition of impermanent loss and how it is related to the liquidity pool. As you learn more about important metrics, you will be able to calculate the difference and avoid it in the future. This is only possible with sufficient knowledge of the topic.
So, let’s start with the definition of impermanent loss.
Introduction to Impermanent Loss
There are lots of risks investors have to face while providing liquidity to their favorite decentralized finance projects. By its definition, an impermanent loss is basically the difference between the values of two different cryptocurrencies within a liquidity pool. It can also happen to you if you hold your crypto assets in a digital wallet.
When you deposit your cryptocurrency in a pool to provide more liquidity to the system, the value of the cryptocurrency can change in comparison to the value when you deposited the crypto. Larger differences in value can mean a larger loss for the investor. No matter if the price is going up or down, an impermanent loss can still happen. If the price of the cryptocurrency you have invested in goes up, the impermanent laws will go down.
This type of loss doesn’t even depend on the crypto pair you’re working with right now and can happen to any cryptocurrency. If your grip toe has not gone through an impermanent loss, you can withdraw it if its value matches the value shown on the exchange at the withdrawal’s time. You can also learn about impermanent loss online or through a brief course.
You will suffer from impermanent loss after withdrawing your funds. It is called impermanent loss because it goes away once the value of your cryptocurrency returns to its initial exchange value with time. Unless an investor takes his funds out of the liquidity pool, this loss remains impermanent.
Calculating Impermanent Loss
The amount of impermanent loss directly depends on the amount of cryptocurrency involved in the deposit. For example, if you’re depositing Crypto in the liquidity pool according to ETH and DAI ratio, you’ll have to deposit the funds in such a way that the ratio is maintained. This way, the total investment becomes larger than the initial amount, and its pool quantity can be calculated by a simple formula (X x Y = K).
If you use this formula, the total value will go to 100 according to the ratio of your investment and deposit. However, both of these values can differ because of the changes in the real-world market. When this happens, traders buy crypto coins that are priced less than the actual market.
When this happens, the amount of one coin decreases in comparison to the other cryptocurrency it is being exchanged for. This continues to happen until the market stabilizes. When the market finally gets stable, investors start to withdraw their deposited funds. This makes a clear difference between the values of the two assets in the pool. You can learn more about this technique in crypto courses and on YouTube.
Whenever the liquidity pool has sufficient funds, investors like to deposit more of the crypto funds they have in their wallets. After doing this, the investor receives liquidity provider tokens, which is basically a summary of your investment in comparison to the already existing investment in our liquidity pool. The percentage of liquidity you provide in a liquidity pool is flexible and changes according to your percentage contribution in a specific pool.
For example, if you invest $300 and bring the total value of liquidity pull up to $2000, the liquid in the pool will provide you with liquidating provided tokens, and you will be entitled to 30% shares of the total pool. However, if the same pool grows to $3000 in a few days, your percentage share in the same pool will only remain 10%.
Once the price of any cryptocurrency increases, investors add more pairs of cryptocurrencies in its liquidity pool to reflect the price in that pool as well. The ratio between different types of assets in the liquidity pool dictates the price of the cryptocurrency as well. This is an important factor to consider when studying the relationship between different cryptocurrencies.
On the other hand, if the price of the same cryptocurrency decreases, the overall change in the ratio will depend on the behavior of the investors. Even if you want to withdraw some of your funds from the liquidity pool, you will have to maintain a certain percentage of funds in the pool if you want to claim a specific percentage share of the profit. This is why impermanent loss exists.
Impermanent Loss Estimation
Just as learning about the block, Jen is easy; you can also estimate impermanent loss easily. Although it is very difficult to calculate the exact impermanent loss, you can at least estimate the extent of it. This loss is dependent on the sheet value and remains the same unless an external factor changes it. So, if you are an investor and are thinking about withdrawing your funds after seeing the extent of impermanent loss, it will become permanent.
Although impermanent loss is very common, you are likely to get a completely different figure than you perceive. For example, if Ethereum’s price goes up in the market, arbitrage traders can still buy it for a lesser price. When a difference in price is introduced between the market and liquidity pool of a crypto token, the investors can deposit it and use other tokens unless a new ratio is achieved. This is the best way to estimate the value of the impermanent loss which can happen in any liquidity pool.
So, you can actually calculate or estimate the extent of impermanent loss to your digital currency tokens in a liquidity pool to some extent. People with more knowledge of the DeFi market can better understand this scenario.
Avoiding Impermanent Loss
When you are investing in a regular market, you will have to suffer from impermanent loss as an investor whenever you deposit your friends in the liquidity pool. Moreover, the prices of cryptocurrencies constantly fluctuate in their market value. Any person with some experience in investing or working in the DeFi market can develop a deep understanding of these terms.
Let’s take a look at some of the best practices you can perform to avoid impermanent loss while trading.
Minimum Volatility
If we take a closer look, this type of loss happens in a volatile market. So, in order to minimize this loss, you will have to choose a pair of cryptocurrencies with minimum volatility between them. For example, you can choose currency pairs like USDT and DAI. There are lots of other crypto pairs with minimum volatility out there, which you can choose to minimize your impermanent loss.
However, make sure that the price of both of the cryptocurrencies in such pairs is nearly the same. This will help you detect any price movements between both of them easily. In a perfect scenario, in which the volatility of a cryptocurrency is zero, there will be no impermanent loss. So, always try to maintain the volatility in the chosen cryptocurrency pair to a minimum.
One Side Pools
When different types of crypto assets are deposited in the same liquidity pool, impermanent loss maximizes. This problem is being mitigated by crypto exchanges by providing the investors with only one side of the liquidity pool while keeping the other side inaccessible for them. You can learn about those exchanges online.
In this unique case, an impermanent loss won’t exhaust because the investor will only have to give access to one side of the liquidity pool. This type of system is still decentralized, and any type of price fluctuation is automatically adjusted by the liquidity pool.
Charging Trading Fees
By including the trading fees in the liquidity pool, we can minimize impermanent loss. This type of trading fee is charged from the traders who are making using the liquidity pool. Once the fees are collected, a specific percentage of it is distributed amongst liquidity providers for providing their services. This solution works perfectly to offset any type of impermanent loss.
When more trading fees are collected, we can make sure that there will be no impermanent loss. This way, the pool can attract more investors without the fear of impermanent loss to their investment.
Less Complexity
Unnecessary complexity around liquidity pools can also maximize impermanent losses. This mainly happens because an equal half investment is needed by the pool. Exchanges these days are introducing specific ratios in their liquidity pool to mitigate this issue and minimize or even eradicate the impermanent loss.
Many decentralized exchanges are using this matter to avoid impermanent loss. Their liquidity pools consist of many digital assets. The ratio of price change is kept higher than the change in the crypto pool ratio. This easily avoids an impermanent loss. While some loss might exist, it is much less than traditional pools, which require an equal half split.
Liquidity Pools and AMMs
To understand the concept of impermanent loss completely, you will have to understand the relationship between liquidity pools and automated market makers.
Every liquidity pool has a pair of cryptocurrencies on it. For example, ETH and DAI have a liquidity pool. There is 50% ETH and 50% DAI in the pool. This is done to make it easier for traders to make trades between these two currencies.
All the funds contained in a liquidity pool are locked with a smart contract. Users can easily conduct trades and lend either of these currencies with the other one to continue their work on decentralized finance platforms.
Whenever you buy a cryptocurrency coin from an automated market maker, there is no seller on the other end. Rather, an automated algorithm controls this activity on the liquid duty pool. Additionally, depending on the trades going on in the liquidity pool, the price of every asset is determined.
In simple liquidity pools, a basic formula always keeps the value of both the cryptocurrencies within a pair the same. The algorithm always allows liquidity no matter how big the trade might be.
However, if the demand of a cryptocurrency rises, the algorithm automatically increases its price, depending on the percentage remaining within a liquidity pool. For example, according to the above-given example, if you buy DAI from the liquidity pool, you are actually decreasing the amount of DAI available in that pool, and the amount of ETH will automatically increase. This will also increase the price of DAI and decrease the price of ETH according to the demand and supply theory.
In larger pools, the effect of one trade on the whole pool will significantly decrease. So, if you execute a trade in a huge liquidity pool, there will be a negligible price difference.
Since the size of a liquidity pool directly influences the trading experience of its users, the investors are usually provided with incentives and additional tokens for providing liquidity in a liquidity pool. This phenomenon is termed liquidity mining.
Working of Automated Market Makers
AMMs are a gem for liquidity providers since they’ve eased a lot of things. These market makers have basically decentralized exchange protocols which are used by liquidity pools to determine the price of different assets.
Instead of using order books, algorithms are used in this process to determine the price. For example, in the case of Uniswap, the x * y = k formula is used.
In this formula, x and y are both of the tokens present in a pair. On the other hand, k is constant and is used to maintain the liquidity of the total pool. So, AMMs are basically algorithms that are used to determine the price of different tokens within currency pairs.
Pools with Impermanent Loss
Although every liquidity pool looks identical, some are more brown to impermanent loss as compared to others. As we already mentioned above, liquidity pools with volatile currency pairs are much more likely to have a high percentage of impermanent loss.
Moreover, currency pairs with significant price differences are also considered to have high permanent losses as compared to the pairs with less price difference. However, there is no fixed method through which you can calculate the impermanent loss before withdrawing your assets.
However, you can minimize your impermanent loss by following the methods stated above in this article.
Examples of Impermanent Loss
Let’s take a closer look at a good example of impermanent loss. If Joe stakes 1 BNB and 100 USDT (the equivalent of 1 BNB at the time of deposit) into the liquidity pool containing 10 BNB and 1000 USDT after deposit, he’ll have a total of 10% share in this particular liquidity pool.
Let’s say the price of 1 BNB becomes equal to 400 USDT after some time. This will automatically mean that the amount of BNB available in the pool will be higher as compared to USDT. This will push the investors to remove a certain quantity of BNB from the liquidity pool to restore the ratio. But now, the amount of BNB you’ll get for the initial deposit price will be low. However, this will increase the inflow of USDT in the system.
After withdrawing the assets, it is now time to calculate and see if Joe suffered from an impermanent loss or not. He will have 0.5 BNB and $200 USDT, which is equal to around $400.
Let’s calculate;
0.5 BNB * $400 = $200
$200 and 200 USDT will be equal to $400. On the other hand, Jeo would have earned $500 if he didn’t withdraw the BNB and USDT.
So, providing liquidity in an AMM will cause impermanent loss, and holding onto your assets will provide you with profit. Since the gains are low, this would be termed as an impermanent loss.
Impermanent loss is termed so because no one can exactly calculate how much it would be unless they withdraw their assets. Moreover, just in case the value of 1 BNB reaches 100 USDT once again, the loss will also be reversed. So, since it changes dynamically with the market, this type of loss is called impermanent loss.
Conclusion
The crypto market is dynamic, and even the loss you suffer from can fluctuate according to the fluctuations in the market. If you wait for long enough, your loss can even go away if the initial value is restored. That’s why it is called impermanent loss.
By following proper measures, you can minimize or even eradicate impermanent loss. So, always do proper research before taking any step in your crypto investment journey.