The surge of DeFi has brought nothing less but a full-scale revolution, changing virtually all aspects of cryptocurrency trading. Before it, cryptocurrency holding has been merely a long-term investment vehicle: a considerable niche in the crypto market, yet devoid of truly profitable methods of maximizing the interest.
The possibility to earn large sums by providing liquidity into the liquidity pools attracted thousands of new investors and expanded the already-large trading network.
Naturally, this highly lucrative method of earning comes with its dangers, the main of which is the impermanent loss. In this guide, we will get the impermanent loss in crypto explained in simple terms. So read on to learn more.
Impermanent Loss in Crypto Trading Explained: What Is It
Even experienced traders may have never heard of impermanent loss since this is a relatively new concept, which followed the introduction of liquidity pools. It describes a temporary loss of crypto assets in the dual-asset liquidity pools in the decentralized systems due to their high volatility. In terms of quantity, this loss is represented by the difference in value between two assets, deposited into liquidity pools.
This problem happens when putting cryptocurrency assets into liquidity pools and withdrawing them later leads to a loss of funds if compared with just holding them. In some cases, such a loss should be regarded not as a loss of money per se but rather as a missed investment opportunity. The client still obtains some profit. However, holding them would be more beneficial.
What Does Impermanent Loss Mean in Crypto Trading?
Unlike many financial terms, this concept has a rather dramatic title. What does impermanent loss mean in crypto trading? The “impermanent” part refers to its probabilistic nature. The loss is calculated only when the customer withdraws their crypto assets. Until then, it remains merely a theoretical danger. Shifts in the market prices may completely eradicate impermanent loss or even bring some profit.
In simpler terms, this situation is similar to horse racing. It may seem that one’s favorite trails behind. Nevertheless, the results are known only when the race ends — the situation may drastically change at any given moment.
Key Concepts
To understand the mechanism of impermanent loss we need to learn more about the crucial elements of a decentralized exchange, namely the following:
● Token Pairs;
● Automated Market Makers.
Token Pairs
A typical liquidity pool contains a pair of cryptocurrencies (for instance, ETH: DAI). A typical ratio is 1:1. This means that such a pool contains 50% of ETH and 50% of DAI. By maintaining such a ratio, a system provides a stable source of liquidity to crypto traders.
Thanks to this system, traders can deal not only without intermediaries but also without actual counterparts. A buyer can buy without waiting for the arrival of a seller and the other way around.
Automated Market Makers
The AMMs are highly sophisticated algorithms that regulate almost all functions within liquidity pools. They raise or lower the prices within a crypto pair according to the shifts in the total liquidity. The general equation represents the relations between the amounts of each cryptocurrency within a pair and the total liquidity.
How Does It Happen
To add liquidity to the pool, you must deposit equal values of each cryptocurrency from the chosen pair. By doing so, you receive Liquidity Provider Tokens, which allow you to obtain a certain percentage of the pool, depending on the ratio between your amount and the total amount of assets in the pool.
For instance, if you are responsible for adding $500 into a $1000 pool, you may get 50% of it. However, any changes in the total amount will also change your percentage. If the pool will grow to $2000, you will get 25% only.
Rapid price movements unbalance different parts of the equation, leading to unique opportunities for arbitrage traders who receive a chance to purchase a token at a discount. By purchasing the cryptocurrency with a lower value, these traders help balance the ratio.
However, this unbalancing changes the number of tokens without changing their value. Liquidity Provider Tokens correspond to the percentage of your investment into the pool rather than an actual amount of deposited tokens.
As a result, when you withdraw your cryptocurrency assets, you end up with a lesser amount of one token and a higher amount of another. Due to the difference in prices, the resulting value of your investment may become lesser in comparison with the same amount of tokens deposited into your account.
Is Impermanent Loss worth It and How to Avoid It
Of course, one cannot get rid of this risk forever. This financial danger is but an innate feature of the current system of liquidity pools: the AMMs simply cannot function without creating opportunities for impermanent loss. Nonetheless, there are plenty of ways to minimize its probability or restrict the loss of crypto assets to a moderate level.
For instance, one may avoid a great number of associated risks by copying the moves of professional traders. The modern market comes with automated tools designed specifically for this task, such as Jet-Bot. This crypto trading mechanism automatically follows the chosen trader, mirroring their moves and making deals under the best possible conditions. It also has automated stop-loss features along with options for increased safety of both long-term and short-term orders. Of course, even such a tool is incapable of eliminating the risk of such loss. Nonetheless, it significantly increases one’s chances to optimize potential profit.
Relying on Low Volatility
Since impermanent loss happens as a direct result of extremely high volatility, it is only natural to try to confront it with low volatility crypto pairs. In general, this strategy revolves around the use of stablecoins. In addition to low volatile pairs, such as DAI: USDT, one can use different versions of the same token, such as wETH: ETH, because in this case, considerable price shifts are highly improbable.
Utilizing Trading Fees
Exchange platforms reward providers of liquidity by sharing with them parts of trading fees gathered from traders. Although never exceptionally high, these rewards often provide enough to mitigate the consequences of using highly volatile pairs of tokens. When a chosen liquidity pool has enough participants, these rewards become very beneficial — a trader obtains more from staking the assets in the pool in comparison to holding them.
Choosing Complex Liquidity Pools
Instead of utilizing the 50:50 ratio, some decentralized cryptocurrency exchange platforms propose other options, such as the 80:20 ratio. Naturally, this ratio helps minimize the consequences of impermanent loss.
Choosing One-Sided Liquidity Pools
The very probability of impermanent loss depends on the disturbance of the balance between two pairs of tokens. What if there was only one token? Some platforms offer users an opportunity to provide for only one side of the equation. The platform’s in-house token balances the other side of the equation. Therefore, liquidity providers remain safe even during rapid price movements.
Final Thoughts
Liquidity pools are open for all potential investors, and their restrictions are minimal. In addition, the offered interest rates are well above the average level. However, just like any method of highly beneficial crypto trading, they have their unique risks the most serious of which is impermanent loss.
Is impermanent loss worth it? Of course, the exact answer depends on the situation in the market. However, when taking into account the generally high profitability of decentralized exchange, its risks seem rather tolerable.
