Uniswap, SushiSwap, or PancakeSwap are some DeFi protocols that have experienced a liquidity and volume burst. These liquidity protocols allow any individual with funds to become a market maker and earn trading fees.
What Is Impermanent Loss?
Impermanent loss occurs when you provide liquidity to a liquidity pool, and the deposited assets experience a price change compared to when you deposit them. Now, the bigger this difference, the more impermanent loss you would experience.
Impermanent loss does have a much effect on the pools with assets that do not experience wild price explosions and stay in a small price range. Stablecoins are a good example of such coins since they remain in a price bracket. Hence, the risk of impermanent loss is reduced for such liquidity providers.
A legitimate question arises: Why do the liquidity providers still choose to provide liquidity and suffer losses. The reason is that there is a counter of impermanent loss. It is trading. In fact, pools such as Uniswap have proved to be profitable because of the trading fees.
On every trade, Uniswap charges 0.3% on every trade that goes directly to liquidity providers. Even the pools that are heavily exposed to impermanent loss can be profitable for providing liquidity if that particular pool is experiencing a lot of trading volume. But, it is important to note that this depends on the deposited assets, the specific pool, the protocol, and even the market conditions at that point of time.
How Does Impermanent Loss Work?
There are two assets in a liquidity pool: ETH and DAI. Now, it is important to note here that DAI or any one asset in the pool is a stablecoin while the other asset would be much more volatile such as ETH.
The liquidity providers are bound to offer equal levels of liquidity in both assets. Now, suppose, for instance, the price of ETH rises.
Since now the price of ETH in the liquidity pool doesn’t match its price in the real world, this becomes an attractive arbitrage opportunity. Other traders will now purchase ETH at a discounted rate until an equilibrium is achieved so that the ratio of DAI to ETH stays balanced.
Now, what happens after arbitrage? A liquidity provider will now have more DAI and slightly less ETH. This is how a liquidity provider suffers impermanent loss; it could have been avoided if the liquidity provider had decided to simply hold the assets.
However, this is an “impermanent” loss; however, it could turn into permanent loss if the provider decides to withdraw their losses.
Now, other than not providing liquidity to a pool, what could be different ways in which impermanent loss can be avoided. Let’s see:
How to avoid impermanent loss?
We are very much aware that cryptocurrencies are a volatile marketplace; therefore, an impermanent loss is bound to happen when a liquidity provider is staking crypto assets in a liquidity pool. Besides, the prices of exchanges are also going to fluctuate. Now, let’s look at the ways to effects of impermanent loss can be countered:
One-sided liquidity pools
In a standard liquidity pool, impermanent loss happens since two different cryptocurrency assets must be deposited. Now, to avoid or mitigate impermanent loss, Exchanges such as Bancor provide liquidity polls that let users stake only one side of the pool. The other side is fixed. For example, the other side of each liquidity pool on Bancor is made up of BNT, the native Bancor token.
Let us understand with an example, for all ETH that a provider provides to the ETH: BNT liquidity pool, the equivalent BNT is added by the system. Since the users are providing only one side of the liquidity pool, they do not run the risk of impermanent loss.
Recently, Bancor has even integrated price feeds with Chainlink, a decentralized oracle. They automatically adjust in case of notable price changes by tying liquidity pools with a live market price. This doesn’t happen in standard liquidity pools.
Low volatility pairs
Volatile cryptocurrency pairings are more likely to suffer impermanent loss. However, the impermanent loss can be reduced if one of the cryptocurrencies pairings is where the exchange price is not volatile. As we see in our example above: ETH and DAI are low-volatility pairs, where DAI is a stablecoin or a pairing like DAI: USDT. Since the assets in our example follow a similar price, mitigating the price movements between the pair. Hence, the impermanent loss is avoided if the price volatility does not exist.
Trading fees
As mentioned earlier, a certain percentage of trading fees is charged from the traders that directly go into liquidity providers’ hands. More often than not, these trading fees lessen the effects of impermanent loss. Naturally, the more the trading fees, the less impermanent loss will happen.
In some cases, it happens as such that a pool can collect more fees an investor would have gained from staking assets in a liquidity pool compared to holding them.
Complex liquidity pools
Among various factors, the core reason behind impermanent loss is the 50:50 split that most liquidity pools require as a prerequisite. Decentralized Exchange such as Balancer provides various options of liquidity pool ratios to overcome this issue. In addition, they also provide pools with more than two digital assets. This is because the price changes in pools with higher ratios, such as 80:20 or 98:2, naturally result in a large impermanent loss compared to pools with a 50:50 split.
Andrew is a blockchain developer who developed his interest in cryptocurrencies while his post-graduation. He is a keen observer of details and shares his passion for writing along with being a developer. His backend knowledge about blockchain helps him give a unique perspective to his writing
Source: https://www.thecoinrepublic.com/2022/03/27/everything-you-need-to-know-about-impermanent-loss-ways-to-avoid-it/