In the world of decentralized finance (DeFiDeFi DeFi services use smart contracts, decentralized protocols, and tokens to offer a range of financial services that can sometimes replace those offered by banks, such as lending/borrowing, asset management, insurance, or asset exchange.), you may have heard of “impermanent loss” (IL).
But what exactly is it?
Impermanent loss affects liquidityLiquidity The ease with which an asset can be bought or sold without affecting its price. providers in decentralized exchange pools. Imagine you provide liquidity to a pool with a 50/50 split between ETH and USDT, contributing 1000 USDT and 1 ETH (assuming 1 ETH = 1000 USDT).
If the value of ETH increases, the liquidity pool will adjust by selling some ETH for USDT. As a result, the value in dollars of your initial investment will not be the same as if you had simply kept your 1000 USDT and 1 ETH. Therefore, the fees earned from stakingStaking The act of participating in a Proof of Stake network by locking up tokens as collateral to validate transactions and secure the network. the liquidity pool (LP) must be greater than the impermanent loss to ensure profitability.
This happens because of the need for the liquidity pool to maintain a balance between the two assets in the pool.
If the value of ETH increases by, say, 10%, and then returns to its initial price, the impermanent loss is effectively neutralized. This is known as impermanent loss.
Using the initial price calculation model for a DEXDEX A decentralized exchange platform without a central authority, often using AMMs to enable trades. like Uniswap (X = y * k):
If the price increases by 50%, the impermanent loss is -2%. For a 2x price increase, the impermanent loss is about -5.7%.
How to Minimize Impermanent Loss?
- Choose Your Cryptos Wisely: Some tokens are more stable than others. Highly volatile cryptocurrencies can lead to greater impermanent loss. Also, consider the profitability (APR/APY); a higher yield might offset the impermanent loss. However, note that yields are variable. When a pair is new, the yield may be high to attract liquidity providers but is unlikely to remain at those levels.
- Diversify Your Assets: Avoid putting all your cryptocurrencies into the same strategy. Having a variety can help reduce risks.
- Be Patient: Remember, the loss is “impermanent.” If you can wait for values to return to normal, the loss might not be as significant.
Mathematical innovations are also being developed to addressAddress A unique string of characters that identifies an entity or account on a blockchain network, allowing the sending and receiving of cryptocurrencies. this issue. For example, Uniswap V3 was launched to improve efficiency. If you’re interested, I encourage you to learn about the concept of Uniswap V3’s LP ranges.
Remember, if the returns you earn from lendingLending The act of lending cryptocurrency for interest. your tokens outweigh the impermanent loss, you are still in profit.
