Even after the cryptocurrency crisis in the middle of 2022, decentralized finance (DeFi) technologies like Uniswap and Curve have approximately $40 billion in total value locked. But what happens if the value of the coin you deposit changes? You can suffer impermanent loss. Therefore , what is impermanent loss?
What Is Impermanent Loss?
When the price of the asset you put into a liquidity pool changes in value, impermanent loss happens. In liquidity pools, when you must give two assets in a ratio and one of the assets is more volatile than the other, these losses are typical. Given the volatility of ETH, a Uniswap DAI/ETH 50/50 liquidity pool where DAI is valued at a fixed $1.00 US may present a chance for transient loss.
Less volatile assets, such stablecoins or coins of a similar kind, are used in liquidity pools, which reduce the danger of temporary loss. As we'll see shortly, you can use uneven and multi-asset liquidity pools in addition to stablecoins to lessen temporary loss.
How Does Impermanent Loss Happen?
Considering contributing to a Uniswap liquidity pool 20 ETH worth $10,000 and 10,000 DAI for $10,000. The cost of ETH then increases to US$550 on a third-party exchange like Coinbase. The calculations show that when there are 10,448 DAI7 and ETH in the 19. pool, the price of ETH on Uniswap will be US$550. Therefore, until the price of ETH equalizes with Coinbase and the wider market, arbitrageurs quickly purchase ETH from the LP.
You would experience an impermanent loss of US$23 following the arbitrage because you would have earned US$23 more by holding ETH as opposed to making a contribution to the liquidity pool. Of course, you must also take into account any income from trading fees that you may have received during the holding period in order to partially offset these losses.
How Do I Stop Impermanent Loss?
The simplest way to prevent temporary loss is to utilize stablecoins, which have a fixed value. For example, Curve only includes assets that have values that are the same or highly comparable, such as stablecoins like USDC and DAI or several wrapped forms of the same underlying asset, like wBTC and sBTC. There is consequently extremely little chance of temporary loss.
A typical alternative is to modify the asset mix in order to reduce the risk of temporary loss. For instance, Balancer deviates from the standard 50/50 weighted model by using variable weights. Because of this, 80/20 pools allow you to keep a higher exposure to some assets. The token's weight in the pool determines how negligible the risk of temporary loss is. Multi-asset liquidity pools are used by other DeFi protocols to increase diversification.
Finally, certain DeFi protocols are investigating brand-new ideas. For instance, Bancor adjusts weights based on external prices from price oracles to reduce transitory loss. As a result, even in the most volatile assets, the protocol can completely eliminate imperative loss. Add , Tokemak makes use of single-sided liquidity pools, where the native token of the protocol assumes the risk of temporary loss in exchange for swap fees and bribe rewards.
The Bottom Line
What Is Impermanent Loss? When the price of the asset you put into a liquidity pool changes in value, impermanent loss happens. Fortunately, the majority of liquidity pools generate sufficient trading fee money to offset temporary losses, and other exchanges have reducing mechanisms for these losses. To use DeFi protocols, it's crucial to comprehend this idea, nevertheless.
