Avoiding Impermanent Loss

| Updated
by Alex Manuylov · 11 min read
Avoiding Impermanent Loss
Photo: Unsplash

Avoiding temporary loss is crucial to liquidity pools. The greater the liquidity, the less your risk of temporary loss. Liquidity provisioning can help avoid temporary loss in liquidity pools.

The one who has jumped on such DeFi bandwagon understands the risks of these liquidity pools. It involves a great amount of financial risk.

Among these would be the temporary loss, which arises as a consequence of providing liquidity into DeFi. While the transitory loss might be counteracted later on, it would also be necessary for owners to understand this and learn how to prevent it.

Throughout this article, we address the threats to liquidity pools and recommend ways to reduce such concerns.

Regarding Temporary Loss

Temporary loss is the decrease in value that occurs whenever the values of the invested resources fluctuate throughout the investment interval. If there’s more of a gap, you have a more significant loss, and a minimum if smaller.

The loss comes as a consequence of placing two cryptocurrencies in an automated market maker (AMM) and releasing them at the next moment with a change in values that seems to be less than what you will have obtained if you kept the coins within your accounts.

A temporary loss would only become evident after you had removed the coins from such liquidity pools.

The term “temporary loss” can be applied to the scenario since you might only notice a loss after withdrawing your resources from the pools. Before withdrawing, any loss experienced would be “on paper” and might wind up disappearing completely or being minimized effectively, based on how the marketplace flows.

​​What Are Liquidity Pools and AMM?

To understand how temporary loss works, it is essential to be aware of liquidity pools or automated market makers (AMMs). The liquidity pools usually contain two coins named as a pair. For example, DAI and ETH make up a pair. The importance of both types of cryptocurrencies seems to be equal so that it is easy for customers to exchange. For example, the ratio would be 50 percent DAI and 50 percent ETH throughout such a pool.

So, liquidity pools have been an intelligent contract-locked aggregate of money. They enable borrowing and trading within DeFi marketplaces.

Whenever you buy a coin on an exchange, there doesn’t seem to be anyone on the other side. Instead, an algorithm oversees the activities of the liquidity pools. The computer has also been deciding the price based on transactions throughout the pools. In simple liquidity pools like Uniswap, there’s a consistent formula-based mechanism that assures the values of the two cryptocurrencies stay identical.

The algorithm manages it by gradually raising a token’s value as its intended amounts increases. Consequently, the price of a token throughout a liquidity pool would be governed by the percentage of such currencies.

In this example, you diminish DAI supply throughout the pool if you buy DAI out of an ETH/DAI pool. Due to it, the value of DAI throughout the pool would rise, while ETH would fall.

Since the volume of the pools increases, the effect that liquidity providers have on reducing pricing gaps is reduced. If you supply liquidity in a bigger pool, then there will be a more inconsequential pricing gap. Although such pools provide improved trading experiences, many platforms started to encourage liquidity suppliers with more tokens to supply liquidity to select pools. Such a method would be more generally termed liquidity mining.

How to Understand AMM?

Automated Market Makers are decentralized trading protocols that use a mathematical equation as their base. Unlike stock exchanges, they do not employ order books. Instead, they employ algorithms to price assets. For example, Uniswap employs the formula:

x * y = k

Throughout such a formula, x and y represent the value of each category of token in the pool.

Conversely, “k” seems to be the fixed constant, which maintains the overall liquidity of the pool the same.

However, all AMMs utilize unique formulas; they utilize algorithms instead of ordering books for a price.

Pools That Can Be Exposed to Impermanent Loss

Certain pools are more likely to experience temporary loss than others. Usually, they involve risky currency pairs. Whereas if the price of a cryptocurrency is also fluctuating for a time, it provides for a riskier coin pair, as price changes would probably lead to temporary loss.

Similarly, currencies that have identical prices might also be liable to temporary loss. However, there seems to be no conventional rule for evaluating temporary loss prior to removing your assets.

Still you can take various measures explained further in such an article to prevent temporary loss.

What About Temporary Loss in DeFi?

As a liquidity supplier, Mr. Crypto will bet 1 ETH and 100 USDT. In accordance with the AMM’s principle, the stakes ought to be equal in value. So Mr. Crypto’s 1 ETH will have an identical value of USDT. Then his stakes will convert to 10% from the total of 10 ETH and 1,000 USD throughout the liquidity pool.

In the future, the value of 1 ETH seems to be around 400 USDT, showing that ETH will have a greater ratio than USDT. However, arbitrageurs need to withdraw their ETH from the pool to reach equality. This alters the actual value of 1 ETH and 1 USDT as arbitrageurs withdraw their ETH from the pools to increase the circulation of USDT.

To determine whether Mr. Crypto experiences a temporary loss or gained from his holdings, he ought to withdraw 10 percent of his part from the liquidity pool of 0.5 ETH and 200 USDT that totaled to $400, as detailed below:

0.5 ETH x $400 = $200

200 USDT + $200 = $400

By giving liquidity in an AMM, Mr. Crypto might have profited $500 if he kept onto his ETH and USDT. It is because 1 ETH has been raised to $400. Even if the loss does not transfer to USD or any fiat money, it has still been deemed a temporary loss as the earnings seem to be lesser than what he might have gained if they had not given liquidity.

Such losses have been termed “impermanent” since it can be difficult to know the extent of the loss until the assets are removed. If ETH’s price rebounds to $100 USDT, then this would be a temporary loss that fluctuates with market dynamics.

The Benefits of Providing Liquidity

The fundamental benefit of liquidity pools is that they allow you to conduct exchanges without dealing with your partner. You do not need to hunt for someone who is willing to give the same value for a currency as you are.

There are many people who trade bitcoin, but few of them know how to bargain. If you have a pool, you can swap even if you do not have these talents.

The second reason is that liquidity pools have a modest market effect. Transactions are generally more fluid when you provide liquidity. This can be due to the fact that you stake tokens and relinquish your right to sell them.

And What About the Limitations?

The most notable drawbacks of liquid assets are temporary losses. Your asset values diminish when they’re liquid.

Since there is no third party in DeFi, your asset’s custodian would be the smart contract. If it gets a bug, you might lose your cash. Investors should try to put their assets in pools less likely to incur transitory losses. We have previously explored them above.

If you come across an AMM offering abnormally high profits, there is no doubt that there is some kind of trade-off involved. The risk must be higher than normal.

No Impermanent Loss

Certain circumstances of liquidity mining can lead to temporary losses, as prices are destined to change. By taking specific actions, you can ensure that you avoid the irreparable loss or at least minimize your losses when prices fluctuate.

How to Use the Stablecoins Pair

If you desire to eliminate temporary loss, make 2 stablecoins liquid. For example, if you supply liquidity to USDT and USDC, there will be no chance of temporary loss as stablecoin values are made to be stable.

One of the biggest disadvantages to this type of mining is that you will not get any benefits from a rise in market. If you are liquidity mining throughout a bull market, there is no reason to keep stablecoins since you will not make any profits on them.

If you are liquidity mining in a lousy market, attempt to give liquidity to stablecoins and earn trading fees; in this manner, you will be benefitting from trading fees without losing any money.

The Trading Fees

In all the situations we have presented, we have not included trading costs. When you utilize a pool, you must pay trading fees. The AMM pays a part of these costs to the liquidity suppliers.

Sometimes, the transitory loss you receive from providing liquidity is enough to counterbalance your permanent profit. The temporary loss diminishes as you increase the number of fees.

Low Volatility Pairs

When supplying liquidity to cryptocurrency pairings, be aware that some are more volatile than others. Providing liquidity to them may raise your temporary risk of loss. For example, if you want to supply liquidity to a particular crypto pairing and researching it you anticipate one of the cryptos will outperform the other shortly, do not provide the liquidity.

However, if you expect both currencies to change in value relative to each other, you can go ahead because it will not make much difference.

The bottom line is to keep track of volatile currencies by analyzing their present and future performance.

Why a Flexible Liquidity Pool Ratio Is so Important?

There is one issue that enhances the possibilities of temporary loss. 50:50 ratios are used most often in order to create a balanced liquidity pool.

There are several decentralized exchanges where you may give liquidity in different ratios. Some exchanges, like Balancer, allow you to pool more than two cryptocurrencies.

When Balancer pools have a better ratio, say 95:5, any price shift does not create as much temporary loss as a 50:50 pool. Thus, if feasible, offer liquidity to these pools.

The Exchange Rate Should Be Normal

When you place an order that gives liquidity to a crypto pair, their rates will automatically move in the market. However, the further they are from the price you choose, the more your irreversible loss.

So, you may have to wait for the value of your crypto coin to revert to its original price and then withdraw your coins. This, however, is not as simple as it sounds because the bitcoin market is highly volatile.

What Is One-Sided Staking Pool

Not all AMMs have two-currency liquidity pools. Some prominent AMMs, like the LUSD, offer a single asset type. In this sort of LP, you may contribute a stablecoin to the pool to assure its solvency.

In return for the liquidity you are given, you will earn a part of the collected liquidation fees of the platform. There is no temporary loss in this situation because there has been just one currency, and there have been no ratios among the two assets.

The Liquidity Mining Programs

Nowadays, there are many systems that distribute tokens to the first users. This allows them to create a system for governance and provides these systems with an easy way to create liquidity early on. In the end, this catches the attention of its early adopters.

Furthermore, liquidity mining algorithms provide another benefit. In several situations, token incentives may make up for any temporary loss that liquidity pools experience. How does this 5 percent temporary loss over through the period of two months if you gained 25-100 percent on your initial investment through token bonuses throughout that timeframe? In the absolute least, such benefits may counterbalance temporary loss; therefore, as a liquidity pool continuously maintain incentivized liquidity pools within consideration.

Zooming Out

Automated market makers are growing in popularity, but they are also causing people to lose money. There are ways to make sure you can use automated market makers safely.

Going forward, Uniswap V3 has placed a focus on concentrated liquidity. Concentrated liquidity pools profits and losses throughout a specified price range instead of throughout the entire price curve. This new and improved paradigm for liquidity pools will be able to contend with recent challenges facing the DeFi space.

Final Note

It’s also important to note that you might lose money, even if the two currencies in the crypto pair experience growth or a fall in price. Regardless of whether the exchange rate increases or decreases, you could still suffer a temporary loss. The only way you can avoid this is if the price at withdrawal is equal to that at deposit.

However, if you would like to benefit from the potential of being a liquidity provider as passive revenue, it is best to assess temporary loss based on the swings in crypto values in the market. Most importantly, when optimizing passive revenue, do not supply liquidity to volatile pairings as they are typically most prone to temporary loss.

If you’re a beginning or intermediate crypto user, these guidelines should be enough to prevent temporary loss. However, if you’re an expert user, apply yield farming tactics to maximize your returns and minimize possible transitory losses.

Guest Posts
Kseniia Klichova
Author: Alex Manuylov

Alex started a media business with a team of 5 people in 2018. He developed the basic concept of the publication, advertising channels and collaborated with media partners. He’s made over 30 interviews, wrote and edited more than 50 long reads. The current circulation of the magazine is 100,000+ copies. Nowadays he is a Product delivery lead in Stakero.

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