For any investor, it is essential to be aware of the related risks concerning decentralized finance, better known as Defi. One such significant risk involved in dealing with decentralized finance is impermanent loss.
In this blog, we will explore the meaning of impermanent loss concerning the liquidity pool. As we unfold the meaning and consequences of impermanent loss, the blog will also discuss how to calculate the difference and why it is essentially happening. In addition to this, we will also discuss several ways an investor can use to avoid it to a significant extent.
Let us go into the details one by one!
What is impermanent loss?
Among various other risks involved in providing liquidity to multiple assets in Defi regulations, environment loss is one of the most common and unique risks that are likely to happen in favorable circumstances. From a practical perspective, an impermanent loss is a net difference between the value of two cryptocurrency assets in a liquidity pool-based automated market maker. It can happen by simply holding the assets in a cryptocurrency wallet.
There are cases where an investor provides liquidity to a pool and the relative price of the deposited asset changes in comparison to their initial value during the deposit. The bigger this difference is, the more an investor is exposed to the loss. It is equally essential to know that impermanent loss can take place irrespective of the price direction. For example, if there is an increase in the price of a cryptocurrency, the corresponding impermanent loss can go down as compared to digital assets deposited in a wallet. However, it can also occur regardless of the cryptocurrency pair currently experiencing fluctuations in its price. A user can only withdraw their digital assets that have not undergone an impermanent loss if the existing exchange price is similar to that at the time of withdrawal. For anyone interested in learning more about it in detail, we would recommend going with a Blockchain certification course for a better understanding.
On the other hand, a user can realize an impermanent loss only after withdrawing the funds. The impermanent nature of this loss exists because the prices of cryptocurrencies can return to their initial exchange price at any given point in time. Once this happens, the loss would no longer exist because it is only permanent if an investor takes their fund back from the liquidity pool.
How to calculate impermanent loss?
Impermanent loss significantly depends on the behavior of investors concerning the ratio of cryptocurrencies involved in a deposit. For instance, if there is an investor who wishes to deposit their funds into the liquidity pool in the ratios of ETH and DAI. Now, let’s say the liquidity in the pool remains the same. No trading fees or liquidity is added or removed from it. If the existing price of one coin is $50, the relative price of one DAI comes to $1 as it is a stable coin. The ratio, in this case, must be split into equal halves so that the investor deposits equal units of both coins into the liquidity pool. Now, as the investment becomes bigger than the initial value, the total quality in the pool will be based on the AMM formula (X * Y = K).
As per the formula, the value comes to 100 depending on the ratio during the initial investment and the last deposit. The difference between the two is due to the fluctuations in real-world market prices. In such cases, arbitrary traders usually prefer to buy a coin with a lower price compared to the real world market price. This behavior leads to a decline in the amount of one cryptocurrency with an equivalent increase in the amount of the other crypto. The process continues till the market stability is achieved and the dilution takes place. Once this saturation level is achieved, the investors usually start withdrawing their funds from the deposits, which leads to a difference between the two values of assets in the liquidity pool. If you wish to learn more about this, you can consider taking up cryptocurrency trading courses for full-fledged learning.
Why does impermanent loss occur?
When there is sufficient liquidity in a pool, investors are likely to deposit an equal value of each asset deposited in their digital wallets. The investor is then likely to receive liquidity provider tokens. It is a summary of your deposits as a certain percentage of the liquidity pool. Usually, it is dynamic and corresponds to the flexibility in liquidity provided by the investor in comparison to the overall amount present in the pool.
For instance, if an investor brings assets worth $300 amounting to a total of $2000, the liquidity pool tokens will entitle a happy 30% of the pool. It is likely to happen when an investor uses them to withdraw their assets at a later date. On the other hand, if other people add their assets to the liquidity pool over time and bring up to $3000, the original investor would be entitled to up to 10% of the entire pool. Let us take another example to understand how this takes place in another scenario. Suppose the price of Bitcoin increases to 500 BITS. As this happens, any given community of arbitrage traders will take the opportunity to add other pairs of cryptocurrencies to the liquidity pool. They are likely to keep adding more currencies into the pool until the given ratio reflects the existing price. At this point, it is essential to remember that the ratio between assets in the pool determines the price. It is the only significant factor that can decide the intensity of the relation between cryptos.
In case the price comes down to 400, the ratio between how much Bitcoin and the unit in the pool has changed depends on the behavior of arbitrage traders. Now, if there is an investor who wants to withdraw their funds, they will have to secure a certain percentage of funds to keep their stake in the profits keeping in mind the original price of their deposit of tokens. To learn more about this, you can go for a good cryptocurrency course from any affiliated institution.
How can we estimate impermanent loss?
As easy it is to learn blockchain, it is also possible to estimate the extent of the impermanent loss. Given the unpredictable nature of impermanent loss, one can also estimate its intensity. Usually, it is based on the sheet value, which implies that it has the potential to keep changing until an external measure is taken. So, whether an investor decides to withdraw their funds after experiencing a trivial price change in the cryptocurrency or not, the loss is likely to become permanent.
Although it is a very common scenario, this is where it gets even more interesting because the user gets a pretty much different figure than usually perceived. For example, if the price of Bitcoin goes up, there is an immense opportunity for arbitrage traders to buy the coin at a cheaper price. Since the new rate for Bitcoin will be different from its older price in the liquidity pool, the users can replace it with another cryptocurrency and put it in the deposit until the ratio arrives at a new rate. It is a common method of estimating the real value of impairment loss that can take place in any standard liquidity pool. Hence, an investor can assess the approximate value of an impermanent loss concerning their deposits in the digital wallet to a certain extent. For a better understanding of how and why this happens, you can also go for any Defi certification course to help you make your understanding sharper as an investor!
How to avoid impermanent loss?
For a given marketplace that is volatile, the impermanent loss is a regular phenomenon when an investor occupies their stake in a liquidity pool. Irrespective of these factors, the exchange prices of cryptocurrencies always keep fluctuating. Many people get well-versed with these methods as they learn Defi basics. However, several other ways can significantly prevent impermanent loss from happening. These include –
By introducing trading fees –
For any given case of impermanent loss, it is essential to ensure that a specific percentage of trading fees is included in the liquidity pool. Trading fees are a charge collected from the traders that equip the liquidity pool. After collecting it from the traders, a certain percentage of the total fees is given to the liquidity providers to facilitate proper management. A lot of times, this amount is enough to deal with any impermanent loss in the liquidity pool.
More trading fees collected means there will be fewer cases of impermanent loss. Once the chain starts, there will be a certain point where a pool will be available with enough fees. This amount would be equivalent to the amount that a particular investor holds concerning their assets in a liquidity pool.
Maintaining low volatility –
If we observe, impermanent loss usually happens in the cases of voluntary cryptocurrencies. Any given state of impermanent loss can be controlled by choosing a pair of cryptocurrencies with less volatile exchange prices. A few examples of cryptocurrency pairs with lower volatile nature include DAI and USDT. There can be other such cryptocurrency pairs with different variations of a particular token.
However, it is essential to ensure that these cryptocurrency pairings must follow nearly the same price. It is a significant condition to ensure and notice the price movements between the given cryptocurrency pair. On the other hand, the impermanent loss can be avoided to a greater extent if the price volatility of a given cryptocurrency there does not exist in the first place. Hence, maintaining low cryptocurrency peer volatility is a potential key to little to no impermanent loss.
Complexity in liquidated pools –
There are many reasons why impermanent loss happens in any liquidated pool. One of the most popular and common reasons among these is the presence of complexity in liquidity pools. It usually happens due to an equal half split needed by most liquidity pools. To overcome this challenge, several decentralized exchanges apply and use a variety of liquidity pool ratios to nullify the overall effect.
One such example of a decentralized exchange that uses this method is the Balancer offer. They offer liquidity pools with multiple digital assets. Keeping in view the behavior of cryptocurrency ratios, price changes usually have a higher ratio that does not allow for impermanent loss. It is far less as compared to the liquidity pools that have a half split.
Single-sided liquidity pools –
One of the best possible scenarios for impermanent loss to happen is where two different cryptocurrency acids are deposited in a single standard liquidity pool. Although some decentralized exchanges now offer liquidity pools with an opportunity to take the stake on only one side, the other side of the liquidity pool is still inaccessible for the user. Bancor is one such example of an exchange that offers an opportunity to the depositor where an equivalent value is added to the system.
In such cases, there is no risk or scope of any impermanent loss because a user has to provide only access to one side of the liquidity pool. The decentralized exchanges price feeds through the decentralized oracle. This enables the liquidity pool to automatically adjust when any significant price fluctuation takes place.
Impermanent loss is a highly disadvantageous experience no investor would ever like to go through. It is almost a nightmare for any existing or potential investor looking forward to channelizing their funds in the form of cryptocurrencies on the blockchain. However, an investor can significantly reduce the possibilities of experiencing impermanent loss with their deposits with the measures we talked about in our discussion. In addition to this, we would highly encourage you to go for high-rated certified Defi training so that you are aware of any other involved risks. It can significantly help you in understanding the basics along with the techniques to any possible complications while dealing in cryptocurrencies on the blockchain.