What is Impermanent Loss? What is Impermanent Loss and how Medium

What is Impermanent Loss? What is Impermanent Loss and how Medium

However, in this case, since the weight of the BAL pool is 80%, we have less impermanent loss. Self-evidently, these pools offer identical exposure to both assets since price changes in either will affect the pool in the same way. 17.179 DAI, or about 5.72%, is what we would have gained if we simply held the assets instead of staking them in the pool. It is important https://www.xcritical.in/ to note that we have still gained on our initial position of 200 DAI, but in this simple example, the optimal thing would have been to hold the assets. Learn about Impermanent Loss, a crucial concept in DeFi liquidity pools, and how to navigate and leverage it. Let’s go through an example of how impermanent loss may look like for a liquidity provider.

What is Impermanent Loss (IL)

It occurs when the price of one asset in a liquidity pool changes relative to the other assets. Impermanent loss occurs due to the rebalancing movements within a liquidity pool, presenting a risk for liquidity providers who stake their assets in the pool. Suppose you decide to provide liquidity to a decentralized exchange (DEX) by depositing 1 Ethereum (ETH) and 1000 US dollars (USD) worth of a stablecoin like DAI into a liquidity pool. In most liquidity pools, an Automated Market Maker (AMM) algorithm is used to maintain the pool’s overall value by adjusting token prices in response to supply and demand.

What is Impermanent Loss (IL)

In order for users of an AMM-powered protocol to swap tokens, there need to be pools of liquidity available to them. When this happens, it presents an opportunity for arbitrage traders who essentially get to purchase one of the assets at a discount, compared to the rest of the market. By taking advantage of this, arbitrage traders end up naturally rebalancing in the pool.

When the total liquidity, k, changes, the ratio of x and y must adjust to remain balanced. The value of the pair must be balanced as required by the system, since this secures accurate pricing. Remember, DeFi exchanges don’t rely on external markets setting the price for token valuation. Several informative articles elucidate the concept and offer examples, yet they consistently present a formula for impermanent loss without providing its derivation. This is not a loss but a 4.2% gain because assets are held in the pool rather than held individually. A 4x price change in either direction results in a 20.0% loss relative to HODL (just like our example above).

Sometimes, these fees are enough to offset the impermanent loss experienced during the liquidity provision. So, it is a good idea to watch out for the AMMs providing some fees for providing liquidity. DeFi platforms have also been incentivizing users to add liquidity to their pools. This is usually done by also giving rewards based on your share of the pool. On Uniswap, liquidity providers can also earn UNI tokens as an extra reward on top of the yield from providing liquidity. This can further increase profit for liquidity providers while simultaneously decreasing the impact of impermanent loss.

Impermanent loss refers to the way that price volatility impacts the value of a stake in a liquidity pool in a different way than if the same assets had simply been held in an external wallet. This loss is only realized when funds are withdrawn from the pool, and can be offset by earning trading fees and pool rewards. Ruby will be offering attractive opportunities to farm RUBY tokens on supported liquidity pools. Bancor is another platform that has implemented oracles with its liquidity pools to help minimize impermanent loss. Since oracles can provide data from external sources, the liquidity pools can be fed data of the price of assets from other exchanges.

We sat down with Amberdata, a leader in cryptoeconomic data, to better understand impermanent loss (IL) and how to navigate it. This guide will offer context to IL by explaining the technology behind automated market maker (AMM) liquidity pools. And it will detail the data resources needed to detect clues before loss occurs. There are several strategies that can help minimize the risk of impermanent loss when trading on decentralized finance (DeFi) platforms that use automated market makers (AMMs). These strategies include using stop loss orders, using AMMs with low slippage, monitoring the market, and using risk management tools. However, it is important to note that these strategies do not guarantee that you will not experience a loss, and DeFi trading carries inherent risks that should be carefully considered.

Liquidity providers take on this risk when adding tokens to a pool in order to earn trading fees. When there’s a larger divergence in the prices of the tokens compared to when they were deposited in the pool, the greater your impermanent loss will be. Although liquidity providers can experience impermanent loss, the yield on their tokens must also be taken into account. If your yield generates higher returns than the amount you lose from impermanent loss then you can receive more profit than simply holding the tokens. Moreover, by receiving yield on your tokens in a liquidity pool, you are also turning them into a productive asset.

This price change leads to an imbalance in the liquidity pool, as the value of the ETH you provided has increased compared to the stablecoin. Impermanent Loss (IL) is a risk faced by Liquidity Providers when they provide their assets to a liquidity pool. Impermanent Loss is the difference in asset value between holding assets in the wallet (HODL) and holding assets in the liquidity pool. The formula above can be charted to show how price changes in a pool can affect the value of a particular liquidity position. As the price moves higher, the liquidity value will fall as you will be swapping ETH for USD on the way up. However, when the ETH price is on the way down, you’ll be weighted more on this asset.

  • If Bob withdrew his funds, he would have made some money thanks to the liquidity rewards.
  • This makes the value of ETH in the pool equal to the value of USDC in the pool.
  • Upon depositing cryptocurrency in the pool, users get the privilege of withdrawing equal portions of the other cryptocurrency in the pair.
  • Keep in mind that liquidity pools around volatile assets are the most significant sources of IL risk.

Even though we have more USDC than initially, the amount of ETH has decreased. You can make estimates of the fees you will collect based on APY data provided by the AMM platform. Using this formula, and manipulating for p, allows you to plot different IL at different price changes. In any case, unless you are developing apps around Uniswap, k doesn’t really concern you. What you need to know is that it is a number that changes only when someone adds or removes liquidity, or when fees are collected on trades. Crypto trading (trading in general, actually) is always a risky business because the industry is volatile.

What is Impermanent Loss (IL)

Decentralized Finance (DeFi) has opened new opportunities for investors to earn interest on their crypto holdings through—Liquidity Pools (LP). However, just as there are two sides to every coin, liquidity pools can offer high-interest rates on one side and can sometimes lead to a downside risk called— Impermanent Loss. Liquidity pools are smart contract enforced deposits of two tokens needed to enable swaps on a DEX. These pairs are usually set at a 50/50 ratio (but there are also uneven liquidity pools).

Impermanent loss can occur when trading on decentralized finance (DeFi) platforms that use automated market makers (AMMs) to facilitate trades. AMMs use algorithms to set the prices of assets and maintain liquidity in the market by holding a balance of the assets being traded. When a trader executes a trade on an AMM, the platform adjusts the balance of the assets in its liquidity pool to match the trade.

While IL presents a risk, it is important to note there are also potential rewards to liquidity provision. In fact, IL may be a trade-off for the potential rewards that liquidity provision offers. By providing what is liquidity mining liquidity to pools, a trader contributes to the overall liquidity in the crypto market and facilitates efficient trading. This, in turn, can result in earning rewards like trading fees or additional tokens.

Share this post

Leave a Reply

Your email address will not be published. Required fields are marked *