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Understanding impermanent loss

What is impermanent loss?

How does impermanent loss work?

Impermanent loss typically affects liquidity pools that are meant to have an equal ratio of tokens, 50/50. In the USDC/ETH liquidity pool the liquidity providers need to provide equal portions of USDC and ETH into the pool. They are then entitled to withdraw equal portions of the pool. When users trade using a liquidity pool, which happens on decentralized exchanges, the ratio will change depending on how many tokens are in each pool, which will affect the price of those tokens.

Why be a liquidity provider?

Although liquidity providers can experience impermanent loss, the yield on their tokens must also be taken into account. If your yield generates higher returns than the amount you lose from impermanent loss then you can receive more profit than simply holding the tokens. Moreover, by receiving yield on your tokens in a liquidity pool, you are also turning them into a productive asset.

Solutions

While liquidity providers can use stablecoins, yields, and rewards to help lessen the impact of impermanent loss they can also reduce this by using liquidity pools that use ratios other than 50/50. Balancer is a platform that offers liquidity pools with ratios like 60/40 or 80/20. When ETH is deposited into a pool that is 50/50 the liquidity provider has to have 50% exposure to another token. With an 80/20 pool, they only need 20% exposure to another token. You can see below how three liquidity pool ratios are affected by impermanent loss differently, with the 95/5 pool seeing the least impermanent loss.

Credit to Balancer
Credit to Balancer

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