Impermanent loss: the “invisible” threat of liquidity pools
If you are thinking of going into DeFi, you must know one of its main risks: impermanent loss.
You may have seen certain platforms called AMMs, among which Uniswap, PancakeSwap, and Beefy stand out, for example.
They enable the buying and selling of tokens and coins in a different way than a traditional exchange.
In the latter, sellers and buyers interact through the order book: the bitcoins I go to sell will be bought by someone or vice versa.
In contrast, AMMs base their operation on liquidity pools, i.e., “pools” containing funds of two or more currencies. These make it possible to buy and sell without necessarily having to “deal” with another live player.
The pools are “filled” by users who wish to deposit their tokens, earning a passive income from the commissions the platform charges on trades.
This operation generates good returns and is definitely attractive. At the same time, however, there are several risks.
In addition to the classic ones of DeFi, an important critical issue is the impermanent loss, one of the aspects to pay most attention to when becoming a liquidity provider.
Before we get to know this enemy, let’s look at the meaning of a few key terms for understanding.
Index
LP, AMM and LP tokens: small glossary
TOKEN LP
By pouring two (or more) tokens into a pool, we obtain a so-called Token LP. It maintains a ratio between the two tokens (usually 50% and 50%) weighted in dollars or other traditional currency.
Since it is a decentralized pool, the value changes according to the arbitrage that maintains the balance between the pool’s assets.
When it is rebalanced, some of our gain may be eroded if either token has moved away from the initial ratio. If things are not clear, no problem: we will see an example in the next section.
AMM: AUTOMATED MARKET MAKER
Turning to AMMs, these are decentralized protocols that, by pooling liquidity in a pool, allow anyone to provide tokens in exchange for part of the fees required to exchange them.
Uniswap, for example, asks users for 0.3 percent fees to make swaps, which are immediately turned over to Liquidity Providers as a reward. In this way, people are incentivized to provide liquidity, thus keeping the coin swapping process stable.
LP: LIQUIDITY PROVIDER
Liquidity provider is anyone who, by providing two different tokens or more, adds liquidity to a pool that is managed by the protocol to execute swaps.
If the platform has many transactions on a given pair this results in higher rewards.
Often high rewards also result from low liquidity in the pool. In this case, in addition to the high risk of impermanent loss, there is also the danger of losing some of the funds paid in.
Caution is therefore a must!
What is impermanent loss? Definition impermanent loss
The impermanent loss is the loss we might incur by providing liquidity compared to simply holding.
The price of individual tokens over the holding period (from when we stake to unstake the LP token) impacts the amount of tokens we would have had in the wallet if we had held the same tokens.
How does the impermanent loss work? Here is an example to better understand:
If 1 ETH (Ethereum) was worth $4000 and we had $4000, wanting to be an LP (liquidity provider) in the ETH/USDC pool (stablecoin) we would go and deposit 0.5 ETH and 2000 USDC. This is because we generally need to maintain the 50:50 ratio in the value of the tokens (0.5 ETH = $2000 and 2000 USDC = $2000).
If ETH were to rise to $8000, withdrawing our liquidity we would have $5650 (0.34 ETH and 2828 USDC). This is due to arbitrage: having to maintain the 50:50 ratio, the pool was modified accordingly, decreasing the number of ETH (now more valuable) and increasing USDC (remained unchanged).
In the hold case we would have obtained $6000 (0.5 ETH and 2000 USDC). In this case the impermanent loss would be at 5.7%.
In fact, we generated a gain but it could have been higher if we had not joined the pool.
The impermanent loss is called this because it is not permanent until we withdraw funds: if ETH were to fall in value, the pool would change and the number of ETH would go up.
In contrast, if we withdraw after major price changes in an asset, the coins would return to our hands and the impermanent loss would become permanent instead.
"Risk impermanent loss or hold? That is the dilemma!"
How to avoid impermanent loss?
Is there a way to eliminate the risk of impermanent loss?
A viable solution comes from pools of equal tokens, such as SOL-mSOL. The former is Solana‘s coin, the latter a synthetic pegged to its price. By doing so, the impermanent loss becomes almost nonexistent.
Equally good is the choice of pools on stablecoin. An example? On the 3pool on Curve, you can put DAI/USDT/USDC. Having the value pegged at $1, it is very difficult to suffer any noteworthy losses: one of the coins would have to lose the peg and undergo large fluctuations, a rather unlikely event.
There are no other solutions, except to keep the trend monitored and withdraw the LP tokens in case a very bullish phase of one of the coins in the pool goes on.
"Some pools make it possible to eliminate or minimize the risk of impermanent loss"
Impermanent loss: never let your guard down!
The impermanent loss is one of the aspects worthy of most attention before providing liquidity to a pool: the risk of erosion of the initial investment could potentially go so far as to make this operation inadvisable.
Only by knowing the dynamics behind the different strategies can we improve our management and control of the platforms and protect our investment.
It is therefore imperative to stay informed, follow coin trends, and be ready to intervene if necessary.
Have you experienced impermanent loss? How do you take action to limit this risk? Tell us about it on our social channels!
