What Is Impermanent Loss In Crypto? Explained Simply For Beginners
Impermanent loss is the temporary loss in value of crypto assets that have been deposited as liquidity in a DeFi pool, smart contract, or AMM (Automated Market Maker). This occurs when the prices of the provided assets fluctuate, requiring rebalancing of holdings to accommodate the price changes. The loss is referred to as impermanent because, as long as the assets remain locked, they are susceptible to further fluctuations, whether positive or negative. Impermanent loss is an effect caused by a divergence in price ratios.
Attractive Gains Met By Significant Loss
Many people have chosen to avoid the whole idea of yield farming or liquidity mining due to the significant risks associated with the sector. These risks generally exclude impermanent loss, which even many crypto users are unaware of. DeFi has been and continues to be a very active avenue of the crypto space, with many predicting significant growth in the years to come. I, too, believe that this is just the start of something that will dramatically change finance in the years to come.
Despite DeFi being an attractive way to earn yield, there is still a lot of development and maturation needed in the space. DeFi hacks are also common. These need to become a thing of the past, at least for the most part. TradFi wants to incorporate DeFi, but these sorts of issues are holding it back. Attractive gains are obviously the biggest drawcard to the sector, with many opportunities offering insane returns.
However, many do not consider the losses at hand, focusing only on the risks. In this scenario, a rug pull or exploit would be considered a risk, but a loss can occur without any of these dynamics at play. A loss can occur even when an asset’s price increases. This is known as Impermanent Loss and can be a hidden enemy that erodes the value of your assets.
The image above is a strong representative of how much capital is locked up in DeFi and yield farming protocols. This confirms that despite the risks associated with DeFi, such as impermanent loss, investors remain keen to use DeFi as an income source and even as a business.
How Impermanent Loss Works And How To Avoid It
When providing liquidity on any Automated Market Maker, deposits need to be of equal value. The AMM protocol operates using a formula to adjust holdings in response to price movements. In essence, purchasing an LP token is purchasing a percentage of the pool. The algorithm or formula adjusts the asset ratios to keep the distribution equal. This means that if one of the assets experiences significant price appreciation, the holdings will be adjusted to reflect that change.
This can cause liquidity providers to exit the contract with fewer tokens than they initially invested if they withdraw liquidity at those prices. However, if an investor chooses to wait and prices return to the original levels at which they deposited, they will be able to withdraw the same amount of tokens as they deposited.
Let’s Dive Deeper Into Impermanent Loss
There is a very simple approach to remove the risk of impermanent loss: use stablecoin pairs, such as BDO/BUSD.
These coins are not supposed to increase in value, and even when they do, it is usually a percent or two. Perhaps BDO is not the best example, as it is known to move outside of the prescribed range. A pair such as BUSD/USDC is probably a better option in this scenario, as a move of over 1% would be considered large. I have seen many who chose to provide liquidity with more volatile assets, such as on Compound, exit the protocol worse off than if they had held those 2 assets in their wallet for the same period.
This means that even after compounding returns, the impermanent loss became a realized loss, putting them in a worse position than simply HODLing. You have to really do your homework and consider the possible scenarios that could unfold, not only the bullish case or the favorable outcome. However, thoughtful research is perhaps one of the most important practices missing from crypto enthusiasts. Risk management is an imperative aspect of DeFi, especially yield farming.
Impermanent loss can be avoided by using stablecoin pairs, and many offer really impressive returns as well. Perhaps something to consider if you have experienced this dynamic play out in your ventures.
Are Yield Farming Rewards Worth The Risk?
Unfortunately, this is not a one-size-fits-all type of answer. Observing the risk/reward ratio of a particular DeFi-based investment opportunity is key, and not all risk/reward ratios are equally structured. To answer this question, you need to assess your own risk profile. If you are averse to high risk, yield farming may not be your best option. Furthermore, high-risk opportunities usually have inflated returns.
These types of returns are usually too good to be true and come from projects with no real use case or purpose beyond yield farming. In such a case, I would avoid yield farming. However, some farms and contracts provide access to credible pairs with strong assets. In such a case, the risk could be acceptable, and the opportunity rather viable. Each situation is unique and requires careful assessment.
Final Thoughts
Stablecoin yields are currently less viable than they were in the early days of DeFi. Some would consider yield in the form of interest on major exchanges like Bybit. This is, however, not investment advice. Please do your own research and make informed investment decisions. DeFi is a very dangerous environment, so take care. All the best! See you next time!