While an impermanent loss is inevitable when staking liquidity in standard liquidity pools, there are alternatives that investors can use to mitigate the risk. Despite the presence of impermanent loss, trading fees can act as a countermeasure to reduce its impact. Farming involves lending your tokens to a liquidity pool or providing liquidity.
Impermanent loss is one of the fundamental concepts that anyone who wants to provide liquidity to AMMs should understand. In short, if the price of the deposited assets changes since the deposit, the LP may be exposed to impermanent loss. As we’ve discussed, some liquidity pools are much more exposed to impermanent loss than others.
IL can be defended against by using a LP that contains assets remaining in a relatively small price range and thus will be less exposed to IL. For example, stablecoins will remain in a relatively limited price range, thus there is less risk of IL for this LP. Sunflower Corporation — a new cryptocurrency derivative exchange focused on the best trading experience and tech excellence. Understanding Impermanent Loss is necessary for any user of AMM platforms.
Now, these tokens need to be equal in ratios to make it simpler for users to trade. Here, the ratio of the total value of each token will be 50% of what is liquidity mining ETH and 50% of USDT. It’s called impermanent loss because the losses only become realized once you withdraw your coins from the liquidity pool.
If John stakes 1 ETH and 100 USDC where the tokens staked are equivalent to the equal value, then 1 ETH equals 100 USDC. Stablecoins like USDC and DAI are pegged to the US dollar value, so these tokens always trade around the $1 mark. In addition, there are other stablecoins such as sETH and stETH pegged to ETH and WBTC and renBTC pegged to BTC. Every one of you can claim your very own Metapro Supercar, regardless of whether you’re already a blockchain wallet pro or a complete newbie.
These could be different stable coins like USDC and DAI or different flavours of the same token such as sBTC, renBTC and wBTC. The risk of impermanent loss in such pools is greatly minimised as there is no asset in the pool whose value is volatile in relation to the other. This is also why Curve’s liquidity pools, or to be more generic, all the liquidity pools that hold stable assets usually attract way more capital than the pool with non-stable assets.
- The more the price deviates from your initial deposit, the higher the risk of permanent loss.
- An uneven liquidity pool is one way to lower IL, although of course it all depends on the performance of the underlying 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.
- So strategy wise this really means that liquidity providing is more of a long term game rather than a short term game.
If you’d like to get an advanced explanation for this, check out pintail’s article. The key is weighing the opportunity costs of HODLing assets individually vs. LPing them to earn extra rewards at the expense of impermanent loss. If the liquidity rewards outweigh the IL potential, then why would a user not participate in liquidity provision?
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Whenever you provide liquidity, you may be getting a lower of the accrued liquidation charges of the platform. It requires an arbitrageur to come along and buy the underpriced asset or sell the overpriced asset until prices offered by the AMM match external markets. Simply put, impermanent loss is the difference between holding tokens in an AMM and holding them in your wallet. By prefunding a pool like this, AMMs avoid the need to pair buyers with sellers.
This is an important part of how AMMs stay operational, but creates a problem for liquidity providers. Impermanent loss is only theoretically “impermanent” because the loss is not realised or made “permanent” until the assets are withdrawn from the pool. 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. When you deposit funds into a liquidity pool, you become a liquidity provider, and as more people trade with the pool, the transaction fees go to the liquidity providers. However, as the pool attracts more participants, the share of fees per provider decreases. With increased funds in the pool, it becomes more resistant to price fluctuations, resulting in lower price impact and less influence from large buyers.
If you’re planning to get involved in the world of decentralized finance (DeFi), you’ll probably be using a liquidity pool (LP). Investing in LPs is a great way to earn passive income; however, it comes with risks. In general, regardless of price movements, AMM protocol users are always exposed to the risk of foregone costs. In comparison to custody, when asset prices rise, a participant’s position grows less; when prices fall, they lose more.
This means that when you withdraw from a pool, you may receive more of one token and less of the other. Assets have grown in value, but less than they would have compared to just holding. The advent of decentralized finance (DeFi) has opened up a world of possibilities for cryptocurrency investors to earn interest on their holdings.
When you supply liquidity, you will be getting a cut of the accrued liquidation fees of the platform. As there is only one currency, there is simply no requirement for ratios. To understand how impermanent loss works, it is vital to first understand liquidity pools (LP) and automated market makers (AMMs). It’s not a real loss, because the loss is measured against the value your investment would have been if the tokens were held outside of the liquidity pool. So if you are measuring your investment in cash, impermanent loss may not cause you to lose money.