It is critical for any investor to be aware of the risks associated with decentralized financing, often known as Defi. Impermanent loss is one such severe danger associated with dealing with decentralized money.
We’ll look at the definition of this phrase in this blog. Then, we’ll talk about how to prevent it when we figure out what it means.
Let’s get down to business!
Impermanent loss: An overview
Impermanent loss occurs when you provide liquidity to a liquidity pool and the price of your deposited assets moves from when you placed them. The more significant the change, the more vulnerable you are to temporary loss. In this instance, the loss is reflected in a lower dollar amount at the moment of withdrawal than it was at the time of deposit
Pools with assets within a narrow price range will be less vulnerable to temporary losses. For example, stablecoins or various wrapped versions of a coin will stay within a relatively limited price range. As a result, liquidity providers have a lower risk of temporary loss in this scenario (LPs).
Let’s look at a basic comparison between a stablecoin (such as DAI) and a more volatile crypto currency (like ETH).
Let’s say a supplier has to supply comparable levels of liquidity in both DAI and ETH, but the price of ETH suddenly rises.
Since the price of ETH in the liquidity pool no longer reflects what’s going on in the real world, this offers an appealing arbitrage opportunity. As a result, other traders will purchase ETH at a reduced cost until the ratio of DAI to ETH reaches equilibrium again, ensuring that the proportion of DAI to ETH remains balanced.
A liquidity provider may end up with slightly more DAI and slightly less ETH after arbitrage. This is because the impermanent loss compares the current value of their assets to what they would be worth if they sat in exchange for a long time.
Only when a supplier permanently removes their liquidity does the loss become permanent.
How to Avoid Impermanent Loss?
Liquidity providers can’t entirely prevent impermanent loss. However, they may take precautions to reduce this risk, including choosing stablecoin pairings and avoiding volatile combinations.
Let’s have a look at some options for avoiding this misfortune.
- By implementing trading fees –
It is critical to guarantee that a particular percentage of trading costs is included in the liquidity pool for every given situation of temporary loss. Trading fees are paid by the traders who provide the liquidity pool. A portion of the total costs is handed to the liquidity providers once it is collected from the traders to support appropriate administration. This amount is frequently sufficient to cover any temporary loss in the liquidity pool.
There will be fewer examples of temporary loss if more trading fees are collected. Once the chain gets going, there will come a time when a pool with enough fees becomes accessible. This amount corresponds to a particular investor’s amount in a liquidity pool for their assets.
- Keeping volatility low —
Impermanent loss is expected in the case of voluntary cryptocurrency, as we can see. Therefore, choose a pair of cryptocurrencies with less variable exchange values to control any situation of temporary loss. DAI and USDT are two instances of cryptocurrency pairs with reduced volatility. Other cryptocurrency pairings with different variants of a given token may exist.
However, it is critical to guarantee that the prices of these coin pairings are virtually identical. Therefore, it is necessary to monitor and keep track of the price changes of a specific cryptocurrency pair.
On the other hand, if the price fluctuation of a specific cryptocurrency does not exist in the first place, the impermanent loss may be prevented to a greater extent. As a result, maintaining minimal bitcoin peer volatility might be crucial to minimizing or eliminating transitory losses.
- Complexity in liquidated pools –
Impermanent loss occurs for a variety of reasons in any liquidation pool. The existence of complexity in liquidity pools is one of the most prevalent explanations. Most liquidity pools require an equal half split, which causes this to happen. To address this issue, some decentralized exchanges employ a variety of liquidity pool ratios to mitigate the overall effect.
Considering the nature of cryptocurrency ratios, price movements often have a more excellent ratio, which does not allow for temporary loss. When compared to liquidity pools with a 50% split, it’s a lot less.
- One-sided liquidity pools –
When two distinct cryptocurrency currencies are deposited in a single standard liquidity pool, one of the most significant potential circumstances for impermanent loss occurs. Although some decentralized exchanges now provide liquidity pools with the option of simply taking a stake on one side, the user still has no access to the other side of the liquidity pool.
Since a user only has access to one side of the liquidity pool in such instances, there is no danger or potential for any temporary loss. The decentralized oracle provides price feeds to the decentralized exchanges. When there is a hefty price movement, the liquidity pool can automatically adapt.
Impermanent loss is a profoundly undesirable event that no investor wants to go through. It’s virtually a nightmare for every existing or future investor who wants to route their assets through the blockchain in the form of cryptocurrency. However, if you take some precautions, you can reduce the money you lose.
Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn’t represent any investment advice or WazirX’s official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.