With the explosion in Decentralized Finance comes new forms of risk for crypto users, one of these risks being something called Impermanent Loss in DeFi.
It is a term you may have come across already if you are using liquidity pools, but it is also something that is not necessarily told to users upfront when they are looking to add liquidity to a pool because it has a really high annual yield.
What is Impermanent Loss in DEfi?
Impermanent loss is what happens when you provide liquidity in liquidity pools, like Uniswap, SushiSwap, or PancakeSwap, and the price of your deposited assets changes (compared to when you deposited them) due to the volatility of the crypto market.
The bigger the value changes, the more you are exposed to impermanent loss. In this case, the loss becomes permanent when a withdrawal is activated. Thus, you’ll have less dollar value at the time of withdrawal than at the time of deposit.
However, it is considered impermanent because you can recover the loss if the token pair returns to the initial exchange rate. From our research, impermanent loss in farming can be avoided with stable coins like USDT and USDC since stable coin prices are meant to remain stable.
Impermanent Loss In DeFi: How Impermanent loss works
If you deposit an asset into a liquidity pool and the value of the asset goes up, the pool automatically adjusts the ratios of each asset in the pair as their prices change, resulting in a different amount when you withdraw your share.
This means that you lose value because if you held the asset in a crypto wallet, the value simply rose and you made a profit, but if it is deposited in a liquidity pool and the asset’s value goes up, it has to adjust for the price increase or your pair is no longer even, and then when you go to withdraw your share, you have less than if you had held it in your wallet.
Now I’m sure you must be wondering since liquidity providers on automated market makers (AMMs) are susceptible to future losses,
Why do they provide liquidity?
Well for the returns mostly and trading fees might help compensate for the temporary loss. If your liquidity pool is providing enough of a return, it will mitigate your loss because you are simply making up the lost amount in the form of rewards. You can then convert them into whatever asset you lost if you wish.
Is Impermanent loss permanent?
It is worth keeping in mind that while you may look at your liquidity pair and see that you have lost a certain amount of an asset, it is only a loss while the pair is still in the pool, it is not realized until you remove the liquidity and becomes a real loss.
So, it may be advantageous to not panic if you see the prices of assets you are providing liquidity for changing and just hold on to your position to keep reaping whatever rewards you are receiving.
What is Impermanent Loss Protection?
Impermanent loss Protection (ILP) is a type of insurance that protects liquidity providers from unexpected losses.
Liquidity provisioning is only profitable on typical AMMs if the benefits of farming surpass the cost of an Impermanent loss.
However, if the liquidity providers suffer losses they can utilize ILP to protect themselves against impermanent loss. Also, note that to activate ILP your tokens need to be staked on a farm.
Investors often claim that you can’t see the full damage of impermanent loss until funds are withdrawn. So when there’s an upward movement don’t panic. I mean it’s called Impermanent loss for a reason, so try and wait it out because immediately the funds are pulled out it becomes a permanent loss.
Although, Institutions do not participate in liquidity pools due to Impermanent loss in DeFi. However, if automated market makers are to gain mainstream adoption by individuals and enterprises around the globe, this problem cannot be overlooked.