Decentralized Finance or DeFi has bought passive income opportunities in the crypto industry. Among many DeFi instruments, one is lending crypto and borrowing money against crypto holdings. However, with crypto lending and borrowing, the biggest risk is the impermanent loss.
However, not many know what is an impermanent loss in crypto and how it affects their crypto trading. Hence, to help you with all the info, I am going to talk about it in brief.
So let’s get into the topic right away:
What is impermanent loss in crypto?
The simplest explanation of impermanent loss would be when the price of your crypto holdings changes compared to when you deposited them in the pool. The larger the price gap is, the more significant the loss.
Impermanent loss happens when you provide liquidity to a liquidity pool and the price of your deposited crypto assets changes over time. The bigger the price change gap is, the more you are facing an impermanent loss.
Pools that contain assets that remain in a small range are less exposed to impermanent loss. For instance, Stable coins are less exposed to impermanent loss. Since these tokens hardly change their value over a short period of time.
But why do people provide liquidity if they are going to face losses? The reason being trading fees can reduce the overall impermanent loss.
For instance, pools on Uniswap are exposed to impermanent loss. But thanks to their trading fees, they are quite profitable.
Since Uniswap charges about 0.3% on every trade that goes to the liquidity providers. So if there is a lot of trading happening in a specific pool, it will be profitable to provide liquidity to the pool even if the pool is exposed to impermanent loss heavily. However, it also depends on the protocol for the specific pool.
How impermanent loss occurs?
A liquidity pool is made of 2 cryptocurrency pairs. For instance, BTC/USDT. Over here, 50% is BTC, and the other 50% is USDT.
So when you are providing liquidity to a pool, you have to deposit equal value of each asset. For instance, $50 of BTC and $50 of USDT.
After depositing your funds, you will receive liquidity provider tokens, also known as LP tokens. These tokens work as a receipt that entitles you to a certain percentage of the pool.
So if you have deposited $200 worth of assets to a pool and brought up the total value of the pool to $1000, then you own 20% of the pool, and you can use it to withdraw your funds at a later date which includes trading fees and other rewards.
However, if other users also start adding their assets to the pool over time and bring up the pool value to $2000, you will only be entitled to %10 of the pool.
Also, there is a unique risk involved in this since you are providing two assets into a pool. Also, as mentioned earlier, you deposit funds in a 50/50 balanced format.
But we also know that different cryptocurrencies’ value fluctuates independently. As a result, one of the crypto assets’ value may increase, and the other asset’s tokens decrease. So it will be something like a 60/40 balance.
Now the problem is, this gives the arbitrage traders an opportunity to purchase one of the assets at a discounted price compared to the rest of the market. As a result, they end up creating a rebalancing in the pool.
Thanks to the rebalancing, the number of tokens on either side of the pool gets changed. Although, the value of the assets remains the same and you will still be entitled to a percentage of the pool.
However, when you withdraw your funds, you may receive more of one token and less of the other. So now, depending on how the price of these tokens changed, you may end up facing a loss compared to when you had deposited your funds in a pool.
How to Reduce or Eliminate Impermanent Loss?
Providing liquidity definitely brings rewards from trading fees. Hence, it is one of the lucrative ways to earn money from crypto. However, one might not be interested because of the impermanent loss.
But luckily, there are a few ways that can help you reduce or eliminate impermanent loss. Such ways are:
Move with Caution
If you don’t know or have a feel of how the market works or how impermanent loss can occur, then it would be a good idea to gain as much knowledge as you can. If You want to learn more about the crypto trading and imperamanent loss in crypto, The Money Mongers has published lots of detailed gudies which you can check.
Once you have some knowledge, start with small amounts that you can afford to lose. Also, when you are indulging in liquidity mining, make sure to have all the caution in mind as to any other crypto trading strategy.
However, here is a little tip: Impermanent loss is less frequent in a sideways market.
Choose Stablecoin Asset Pools
If you cannot handle huge risks, then it would be a good idea to choose stablecoin asset pools. Such as DAI:USDT, TUSD:DAI, UST-USDC, and many others to avoid impermanent loss.
Since these coins are pegged to the US dollar. As a result, these coins don’t fluctuate as much as a cryptocurrency like Bitcoin.
But you should also know that taking a lesser risk means fewer rewards. So you might not be earning a crazy amount compared to high-risk pools.
Consider One-Sided Asset Pools
One sided pools are much better than pools that require you to deposit two tokens and maintain a balance. Since, in such pools, one token value might increase compared to the other one.
But in one sided asset pools, you only deposit one token. As a result, the risk is less. But you also have to accept the fact that you won’t be earning crazy rewards in such pools.
Opt for Uneven Liquidity Pools
You can also opt for uneven liquidity pools. There are way too many liquidity pools that don’t require you to maintain a 50/50 balance. Platforms like Balancer and Bancor offer you a ratio like 80/20, 60/40, or other variations.
Is Liquidity Mining Worth It Despite Impermanent Loss?
Unlike the traditional markets, the crypto market has always been crazy. It is highly volatile, which brings both profits and losses.
Also, the high volatility contributes to the impermanent loss. However, this does not mean that you cannot earn a passive income by providing liquidity mining.
It is one of the lucrative opportunities that many crypto investors are taking and earning a passive income.
However, as an investor, it is important that you calculate how much risk you can take and how things really work. Then only you would be able to plan your finances ahead and earn from liquidity mining.
Final Words:
So that was all for what impermanent loss is and how it affects your crypto trading. I hope this has helped you with all the information you need. In case you have any other questions, do feel free to drop a comment below.
