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What is Impermanent Loss and How to Avoid it

What is impermanent loss, and is it permanent?

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Impermanent loss (or divergence loss) is a potential risk faced by DeFi investors. It describes the type of loss that a liquidity provider has to bear when the value of a crypto asset deposited into an AMM (automated market maker) differs from its value if it was just held in a crypto wallet.

The volatility factor can turn out to be an investment risk if the digital currency is deposited in an AMM or DeFi pool. In a liquidity pool, the make-up of tokens is regulated by an algorithmic formula that balances the ratio of tokens in the pool. And as AMM formulas prioritise balancing the ratios of the tokens in the pool, your asset value could differ from its value outside the pool, leaving you at a loss. In the event of significant divergence, the gravity of impermanent loss also increases, affecting the crypto portfolio of a liquidity provider.

A ‘Liquidity Provider’ refers to an individual who deposits his/her crypto assets in a liquidity pool, which lets them earn passive income. It also facilitates the trading of crypto assets on a crypto liquidity pool.

In spite of the risk, liquidity providers are still willing to deposit their assets, as it is possible to offset such a loss (partially or completely) by collecting fees. This fee is usually paid by decentralised exchanges. Exchanges with more volume can pay a higher fee, which in turn lowers the degree of potential losses for providers.

What is impermanent loss and crypto liquidity pools

Impermanent Loss Explained

Impermanent loss usually happens when the price of your crypto assets changes after you have deposited them into a liquidity pool. Impermanent loss is directly proportional to the change in value i.e. greater the difference in a value bigger the potential loss.

Impermanent loss can only be felt when a liquidity provider has withdrawn the crypto assets from a crypto liquidity pool. By holding back such withdrawal, a loss might disappear entirely or partially. In a few cases, liquidity providers don’t even lose their money. However, the gain won’t be higher than if the cryptocurrencies were held in a digital wallet.

As mentioned above, investors are still willing to deposit their cryptocurrencies in a DeFi pool despite the chances of impermanent loss. In fact, liquidity providers can counteract the loss by receiving trading fees. 

Trading fees refer to a particular amount that an individual requires to pay when buying or selling cryptocurrency. While making such a transaction, a wide range of percentages or rates is also added to the basic fees. Besides, trading fees fluctuate among different crypto trading exchanges, rendering crypto liquidity pools profitable even if they are exposed to impermanent loss.

Table 1: Trading fees across popular exchanges 

How Does Impermanent Loss Happen?

The major cause of loss relates to the working of AMMs. These market makers allow investors to trade crypto assets without the permission of their holders.

By funding a liquidity pool, anyone can act as a market maker. The AMM 50:50 platforms facilitate through pairing trades, maintaining equal total values, and charging investors a trading fee.

An Example of Impermanent Loss

For example, George invests in a liquidity pool by depositing 1 ETH and 100 USDT. At the time of making such a deposit, the crypto pair should have an equivalent value, where the value of 1 ETH is equal to 100 USDT. Let’s suppose there are a total of 10 ETH and 1,000 USDT tokens in this pool that are deposited by other liquidity providers like George. Hence, George owns a 10% share of this pool with liquidity of 1,000.

If ETH increases to 400 USDT in price, arbitrage traders will remove ETH out of the pool and deposit USDT into it. This is done until the ratio starts to reflect the prevailing value or price. Although the ratios of the assets may change, the liquidity of a pool stays constant.

With the price of ETH exceeding up to 400 USDT, the ratio regarding the amount of ETH and USDT in a pool also changes. In this case, the pool would contain 5 ETH and 2,000 USDT. If George plans to withdraw his cryptos, he can withdraw 0.5 ETH and 200 USDT (total 400 USD).

He managed to turn a profit, as the original combined value of his deposited cryptocurrency was 200 USD. However, George could have made more profits by holding his 1 ETH and 100 USDT, as the combined value of his deposits in dollars now amounts to 500 USD.

Hence, one can suggest that George should have gone for HODLing (Holding a Cryptocurrency) rather than relying on a crypto liquidity pool. In the above example, the impermanent loss George experienced wasn’t substantial, as the initial deposit was on the lower end. However, imagine how much the impermanent loss would be in case of huge deposits.

That said, in many instances, the fees earned could easily negate the losses. So, investing in a liquidity pool could still be profitable even if the cryptocurrency value changes.

Formula for Calculating Divergence Loss in DeFi

In order to calculate impermanent loss, we will consider the experience of only one liquidity provider named ‘Oliver’. The Uniswap pool has an AMM 50:50 scenario with 50% ETH and 50% USDT. Oliver deposits 10 ETH and 1000 USDT to this pool.

Let’s suppose the worth of ETH was $100 USD when Oliver entered the crypto liquidity pool.

1 ETH = 100 USDT

The pool consists of 10 ETH and 1000 USDT

When ETH doubles to $200, the price of 1 ETH would be equal to 200 USDT. At this stage, arbitrageurs step in and buy all the ETH in the DeFi pool until it matches external exchanges.

Using the X * Y = k formula to calculate divergence loss, where the value of ETH isat $100, the pool contains:

8.071 ETH and 1614.21 USDT

When ETH price equals $200, the liquidity pool contains:

$1614.21 + $1614.21 = $3228.42

If Oliver doesn’t deposit his 10 ETH and 1000 USDT, the value of his crypto assets would be:

$2000 + $1000 = $3000

Hence, the calculated impermanent loss is:

$3000 – $3228.42 = $228.42

Which Pools Are Prone to Impermanent Loss?

Crypto liquidity pools containing a high price range or volatility are relatively more exposed to impermanent loss. Stablecoins manage to stay at a contained price, which significantly reduces the risk of impermanent loss.

On the other hand, pools with a limited number of crypto assets are also prone to impermanent loss.  Since there are fewer swaps or trading, there would be fewer fees for liquidity providers, which makes it harder for them to counteract instances of impermanent loss.

How Do You Avoid Impermanent Loss?

Crypto assets are volatile, as exchange prices tend to fluctuate. However, you can still avoid impermanent loss by taking note of the following:

Choosing a DEX with Measures to Protect Against Impermanent Loss

Bancor is all set to update its protocol to try a new approach against impermanent loss.  The issue usually occurs due to arbitrage traders, who are an essential part of any crypto liquidity pool, as they try to compete with other markets by mitigating the prices.

Bancor has tried to eliminate the impermanent loss through the latest update. This approach appears to be based on oracles. It helps to read the true prices of every crypto asset without relying on arbitrage. However, this approach has its drawbacks. For instance, fast traders can exploit oracles since they update slowly.

Avoid High-Volatility Pairs

By using less volatile crypto pairs, it is possible to mitigate the impermanent loss. For instance, you can consider stablecoin pair i.e. USDT: DAI. Since the price of these cryptocurrency pairs is similar, you won’t see a significant price change. This can help to avoid impermanent loss when depositing in a crypto liquidity pool.

Stablecoin pairs give you a chance to take advantage of the minimum price difference. In addition, this type of pairing allows you to identify the relative worth of paired coins. For instance, how much USDT equals DAI.

Usually, fiat-backed stablecoin trading pairs are pegged to USD. These stablecoins may hold one-to-one USD as physical reserves. A DeFi pool or exchange may offer a variety of low-volatile pairing options. With this, you can mitigate the issue of impermanent loss.

Generate High Yield with Lower Risk with Cabital

If becoming a liquidity provider sounds like a daunting prospect, you may want to consider lower risk alternatives of generating passive income with cryptocurrency, like opening a crypto interest account. With a crypto savings account like Cabital Earn, you can deposit cryptocurrency like Ethereum, Bitcoin, and USDT and earn leading APY rates on your deposits. 

Cabital removes the complexity of the user participating directly in DeFi, where a liquidity provider has to constantly track and move their assets across different projects to maximise their returns. Instead, all you have to do is deposit the crypto of your choice, and start earning interest based on the fixed or flexible savings plan that’s right for you. 

Even if you’re new to crypto and you’re thinking of investing in cryptocurrency, Cabital makes it easy for you to buy crypto, earn, and cash out your earnings. If you’re in Europe, you can buy crypto with Plaid, SEPA and FPS by depositing cash and converting it to the digital assets of your choice. 

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