DeFi Explainer: What is Impermanent Loss?

The DeFi space is always striving and improving on a constant basis. Many new terminologies surface with the addition of new concepts and applications. At the same time, people are constantly hit with new lingos that seem to surface in a new convention. From Liquidity pools to staking and farming…many seem to be lost. With the growing popularity of DeFi platforms, more and more users are starting to dive deep into the crypto space. Automated Market Making (AMM) platforms such as Uniswap are taking off and became one of the most popular platforms. However, with this technology exists one fundamental issue. This issue comes from users who provide liquidity to AMMs, as they most often lose their staked tokens just for simply holding them. In this article, we’re going to talk about what is impermanent loss, and how to mitigate any risk that comes with it.

What are Liquidity Pools in DeFi?

Before we tackle what impermanent loss is, we need to explain what liquidity pools are. In the Decentralized Finance (DeFi) space, liquidity pools rose to fame to provide liquidity seekers…liquidity. For example, brokers who offer short-selling often lend their traders money before they get it back with some instant profits. When the trading volume becomes very high, those brokers will need more liquidity, because taking the risk of the other side would put them in great exposure. That’s why liquidity pools came to be. They are basically pool crypto investors’ funds and give them to brokers, who in turn lend it to their traders. Once traders close their trades, those brokers take back this amount plus a fee, then give back the loan to those liquidity pools and split the fees with them as well.

For Automatic Market Makers (AMM) such as Uniswap, the broker (the middleman) is out of the equation. So liquidity providers directly fund those traders on an AMM platform and earn fees for holding their tokens in the liquidity pools. The difference between simply hodling and staking in liquidity pools is that when you do the latter, you earn passive income while your token appreciates in value. With higher rewards come higher risk, and that’s where we talk about impermanent loss.

So What is Impermanent Loss?

Simply put, impermanent loss is the difference between holding your tokens in an AMM and holding your tokens in your wallet. This usually happens when the price inside the AMM pool drops or rises. The bigger the drop or rise, the greater the impermanent loss is. Notice how it is called “Impermanent” as if you did not liquidate from his position, the loss is still “unrealized”. To make it easier, consider yourself trading an asset, and its price starts to fall. Your broker would then show you your “Unrealized P&L”, which is a loss in this case. The price of the asset might rise again and you might become in the green again, but if you close your position, your loss becomes “realized”, hence “permanent”. For liquidity pool staking, that is the exact same thing, but called “impermanent” instead of “unrealized”.

So impermanent loss happens because of price fluctuations, where liquidity providers take the other side of the trade in an AMM environment against traders.

How does AMM pricing works?

AMMs are disconnected from external markets, and this is a crucial idea to understand. This means that if the price of a specific token changes on external markets, the price will not adjust on the AMM. In order for prices to change, it requires a trader to come and buy the underpriced asset or sell the overpriced asset offered by the AMM. During this process, the trader will extract the profits from the pools, which results in an impermanent loss.

How to Reduce risk when Staking in LPs?

There are many ways to protect yourself when staking in liquidity pools. The first way is to participate in liquidity pools that have stablecoins. Since prices of stablecoins are pegged, this price change will not happen, and impermanent losses are avoided.

Another way is to participate in pools that offer a higher asset distribution model. Standard pools offer a 50:50 model where users deposit 50% of one asset and 50% of the other. Other pools offer a higher ratio such as 80:20 or even 96:4, which helps reduce the risk of an asset that might be risky or volatile.

A final way to help mitigate impermanent loss is using Bancor V2 pool which helps the user adjust the weights automatically according to external prices from the price oracles.

Conclusion

When there’s a higher reward, a higher risk often arises. Participating in liquidity pools is definitely one way of earning passively in DeFi, but users should know the repercussions that might happen. The Iron Finance story definitely shocked investors worldwide, leaving them with big losses. That’s why it is always advisable to only invest money you can afford to lose. Always know your downside, ready up for the worst, and do your own research whenever you do any investment, specifically when participating in liquidity pools. Research the platform, the tokens, the history and check your risk appetite.

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