Impermanent Loss and Top 5 Ways to Avoid It
Impermanent loss is a risk usually associated with decentralized finance (DeFi), specifically yield farming and liquidity providing. So what is it exactly and how do you protect your money from it?
The Definition of Impermanent Loss
The existence of decentralized exchanges (DEX) like PancakeSwap, Uniswap, QuickSwap have enabled anyone to provide liquidity and become a market maker. DEXs and traders benefit from better liquidity while those who provide liquidity can receive a percentage of trading fees. It's a win-win-win situation.
Yet things are not as easy as it seems. Latent is the risk of impermanent loss for all liquidity providers. When they put their funds into a liquidity pool, the price of the related tokens are subject to change. Considering the volatility of cryptocurrency, the risk is pretty prevalent.
The loss that occurs when the tokens are in a liquidity pool compared to if they are just held in a crypto wallet is called impermanent loss. This type of loss is considered "impermanent" because it is only realized and becomes "permanent" when you withdraw the deposit. Interestingly enough, impermanent loss happens whichever way the price moves, no matter up or down. The bigger the change in price, the bigger the impermanent loss.
Let's look at an example to better understand the concept of impermanent loss.
Bob deposits 10,000 BGB and 100 USDT into a liquidity pool when 1 BGB = 0.01 USDT. In total, he puts 100 USD into that liquidity pool. Let's also assume his deposit takes up 10% of the pool, so there is a total of 100,000 BGB and 1000 USDT in the pool.
After the deposit, BGB price rises to 0.1 USD. Traders will add USDT and remove BGB until the new ratio is now 0.1:1.
The liquidity pool now is 31,622.78 BGB and 3162.28 USDT. (The product of BGB and USDT remains the same while the ratio changes)
Bob decides to withdraw. As his share is 10% of the pool, he gets 3162.28 BGB and 316.23 USDT, totaling 632.46 USDT. He has made 432.46 USDT in profit, a pretty nice amount.
(In this example, the liquidity pool doesn't have rewards for liquidity providers, which is not very common in real life and means a less handsome profit for Bob.)
But if Bob simply holds 10,000 BGB and 100 USDT in his wallet, that amount would become 1100 USDT after the price increase.
The difference between the 632.46 USDT gained in liquidity providing and 1100 USDT gained in simply holding the tokens is referred to as impermanent loss.
If Bob decides to wait until BGB price returns to 0.01 USDT to withdraw his deposit, then the impermanent loss would disappear.
As stated above, the liquidity pool in this example doesn't offer incentives for liquidity providers, and this is not very common in most DeFi protocols. In real life, most liquidity providers earn trading fees for rewards, and the trading fees are, in many cases, enough to make proving liquidity more profitable than simply holding the tokens.
Top 5 Ways to Avoid Impermanent Loss
The easiest (and undoubtedly most negligent) answer to this question is to not provide liquidity at all. You don't provide liquidity; you don't encounter impermanent loss.
But in case you still want to provide liquidity to get rewards and mitigate the risk of impermanent loss, we are here to help.
First thing first, you have to understand that one of the most important factors that influence the extent of impermanent loss is the price volatility. Repeat after me: The bigger the change in price, the bigger the impermanent loss.
Therefore, you should choose liquidity pools with less price fluctuation, aka those with stablecoins. The more stablecoins, the less volatility, the lower risk of impermanent loss.
You can find out more information on how to get great APY on stablecoin with Bitget here.
To get better rewards for providing liquidity and offset the impermanent loss, you can opt for new liquidity pools that just opened, so you claim a better share of the liquidity pool and earn more rewards.
Another way to prevent this type of loss is to consider pools that have high commission rate and APY that can potentially negate impermanent loss to a certain extent. But pools with extremely high commission rate and APY usually entail large price movement, so you need to DYOR carefully before committing your funds.
Nevertheless, the best thing to do to avoid impermanent loss is to not be too greedy with trading fee rewards and to withdraw your deposits early before the price moves too much.
Disclaimer: All products and projects listed in this article are not endorsements and are provided for informational purposes only. This article is for educational purposes only and is not intended as investment advice. Qualified professionals should be consulted prior to making financial decisions.
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