Providing liquidity to liquidity pools helps the markets function and can rake in profits for liquidity providers (LPs) but it’s crucial to understand the risks of one’s DeFi plays. This lesson will teach you about impermanent loss, and the importance of portfolio diversification in the DeFi world.
Impermanent loss is the value difference between two scenarios – simply holding tokens, and depositing tokens in an AMM’s liquidity pool. It occurs when your deposited tokens are lower in value when withdrawing from the liquidity pool than when you were just holding the tokens. And the more significant the value difference, the greater the ‘impermanent loss’.
The term ‘impermanent loss’ is, in fact, quite misleading. You do not lose money in the traditional sense but rather, your deposited tokens are worth less compared to if you had just held them without doing anything.
The more volatile tokens you provide to a liquidity pool, the higher your chances of experiencing impermanent loss. If you deposit a low-cap altcoin, for instance, an impermanent loss is probable. So if you are an LP who wants to minimize your chances of impermanent loss, depositing stablecoins would be a better option.
Cushioning the impact
DeFi protocols share their trading fees and native Liquidity provider (LP) tokens with LPs in return for their contributions. If you are an LP, these returns may enable you to keep your bottom line positive even if you experience impermanent loss.
As such, impermanent loss doesn’t always result in actual losses on your DeFi strategy. Even if you experienced impermanent loss, token rewards can still make your DeFi play profitable through the earned fees.
It is also important to note that impermanent loss is realized only when you withdraw your tokens from the liquidity pool – before that, they are merely theoretical. Suppose you have staked in a liquidity pool and are expecting losses because of market volatility.
In this situation, you may wait for market changes to remove potential losses before withdrawing your tokens, thereby eliminating the chance of impermanent loss.
A beginners’ guide to impermanent loss
We will now look at an example of impermanent loss that occurs when withdrawn tokens are worth less than tokens that are simply being held.
Liquidity pools usually require LPs to add token pairs based on a 50:50 ratio. If you want to add 1 ETH to an ETH/USDT liquidity pool, you must also add the equivalent USDT amount. Assuming 1 ETH = 100 USDT, you must deposit 100 USDT. And if the entire pool contains 10 ETH and 1,000 USDT in total, your share is 10%.
If the price of ETH soars to 200 USDT after you make your deposit, you would miss out on a 100 USDT profit that you would have made if you had held the deposited tokens in your wallet instead of staking them in the liquidity pool. In this case, your impermanent loss is 100 USDT.
You can calculate impermanent loss by comparing the amount you got back from the liquidity pool to the value you would have gotten if you had held your tokens without a liquidity pool deposit. But bear in mind that the loss may only be temporary and that you may have earned a good amount from the trading fees.
But why? We’ve already established in this example that 10% of the total transaction fees accumulated in the staking pool belong to you. Assuming that ETH’s price remains the same and the trading volume in the liquidity pool remains at 100 ETH since your staking, you would earn 0.3 ETH worth of tokens for providing revenue. As liquidity pools usually pay out the fees in pairs you supply, 0.3 ETH translates to 0.15 ETH and 15 USDT.
These fees can beat the impermanent losses you may face when you withdraw tokens. Of course, you can also choose not to withdraw the tokens and keep enjoying the rewards while waiting for a better time to withdraw.
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