What is Impermanent Loss and How to Avoid it
In a world where cryptocurrency is integrating with the global financial market, impermanent loss remains one of the popular downsides of yield farming and other forms of liquidity mining.
While staking, as a form of generating liquidity, allows investors to input money into the blockchain network in a bid to verify transactions and gain rewards, yield farming, on the other hand, allows network participants to lend their tokens to a liquidity pool and earn substantial rewards. And the measure of these rewards vary with existing protocols.
For instance, a liquidity sharing and lending protocol like CrossFi provides rewards for its participants through momentary swap opportunities and governorship top-ups, which may or may not be entirely different from the approach(es) of other protocols.
Notably, in some ways, yield farming presents more profit than holding. However, there are multiple risks that affect liquidity providers, especially those on Automated Market Makers (AMMs), ranging from liquidation to price control and regulation. Among these chief risks is impermanent loss whose risk level is defined by the number of tokens and liquidity providers participating in the liquidity pool.
What Is Impermanent Loss?
Impermanent loss refers to the change that occurs in a token price between the period of deposit and withdrawal. More elaborately, it’s a fall in price of assets or liquidity that occurs after being deposited in a liquidity pool. Or the difference between the token’s value in the liquidity pool and the theoretical value of its underlying tokens if they haven’t been paired.
When you deposit double tokens into an automated market maker (AMM) and withdraw them at a later time when the liquidity price is less than what you get as reward while holding the coins in your wallet, impermanent loss is relatively bound to occur. That’s to say: the greater the difference, the higher the accumulated loss; the smaller the difference, the lower the accumulated loss.
This loss can only be recorded once the liquidity is withdrawn from the pool. In some cases, what you get as a reward is lower than what you’d have gotten if you had kept the coins in your wallet. In other cases, you don’t lose any quarter of your money. Thus, it depends on the dynamism of the market.
Let’s say, a liquidity provider, let’s call him Ken, having 10 FIL decides to offer funds to a 50/50 FIL/CRFI pool. Assuming in this scenario 1 FIL equals 1000 CRFI, they will have to deposit 10 FIL and 10000 CRFI into the pool. If the cross-chain pool Ken is committed to has a collective asset value of 100,000 CRFI (which is approximately 50 FIL and 50,000 CRFI), his share will be equivalent to 20%. After two months, the price of 1 FIL becomes equivalent to 800 CRFI, which simply means that the ratio of FIL is now higher than that of CRFI. In this case, the arbitrageurs ought to remove a bit of FIL from the pool to strike the needed balance. And consequently, this change in ratio affects the original value of FIL and CRFI since FIL is removed from the pool to boost the flow of CRFI.
To understand if Ken suffers an impermanent loss or amasses great profits, he will first of all need to extract his 20% from what’s remaining in the liquidity pool. Your answer is right. Ken’s gain is almost 50% lower than he would have had if he had held his coins and provided no liquidity. This process is known as “Impermanent loss” because the loss is realizable only when your funds have been entirely withdrawn from or reduced significantly from the liquidity pool. This is because if the price of FIL returns to its original value of 100 CRFI, the impermanent loss is wholly reversed.
How to Avoid Impermanent Loss
As with different spheres of the world of finance, profit is never a guaranteed outcome. In the case of liquidity mining, once the market is volatile, impermanent loss, among other risk levels, is inevitable. The reason is because token prices can rise and fall at any time. Nevertheless, here are some ways one can avoid impermanent/ temporary loss, or avoid greater losses when prices fluctuate.
Use of Stablecoins Pair
One of the strategies to avoid impermanent loss entirely is to make two stablecoins liquid. This is because the value of stablecoins are created to be stable, therefore canceling out any risk of value loss. There’s a major downside to this approach: liquidity providers who use stablecoins pairs are not likely to gain from the rise in the crypto market. However, liquidity miners in a bear market can offer liquidity to stablecoins and earn trading fees without losing money. It’s also good to choose pairs that are not susceptible to market instability and risks.
Invest in Low Volatility Pairs
There’s no mistaking that some crypto pairs have higher volatility than others. Hence, to provide liquidity to them would increase a provider’s risk of impermanent loss. It’s good to study the market and monitor the current and future performance of cryptocurrency pairs you’re interested in before providing liquidity to them.
Opt for a Flexible Liquidity Pool Ratio
Most AMMs have a 50:50 ratio; and this encourages impermanent loss. Because, to follow such a course, they will want to keep the liquidity pool in equilibrium. In a bid to avoid this, one needs to swerve towards decentralized financial applications that create liquidity in different ratios.
CrossFi is a cross-chain protocol that provides liquidity to you for Filecoin staking and rewards.
CrossFi Official Website: https://crossfimain.com
CrossFi DApp Address: dapp.crossfimain.com
CrossFi Official Twitter Account: https://twitter.com/globalcrossfi
CrossFi Official Discord Group: https://discord.gg/UKGSX3VBY3
CrossFi Official Global Telegram Group: https://t.me/crossfimain_en