What Is Impermanent Loss In DeFi & How To Avoid It?
Impermanent loss is a risk in DeFi liquidity pools where the value of your deposited assets changes. This means you might end up with less profit compared to just holding onto the cryptocurrencies. It affects those who provide liquidity to decentralized exchange (DEX) pools. In this guide, we'll explain how impermanent loss works and share tips on how to minimize it!
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What is impermanent loss?
If you're new to the concept, let's break down what impermanent loss (IL) is.
Impermanent loss can be tricky for beginners. In simple terms, impermanent loss happens when your investment loses value due to the mechanics of liquidity pools.
Here's an example:
Imagine you deposit two different coins into a liquidity pool. By doing this, you're allowing traders to exchange these coins back and forth. In return, you earn fees from these trades. Typically, there are many other investors involved, and everyone splits the fees based on their contribution.
Impermanent loss occurs when the values of the two tokens you deposited change relative to each other.
For instance, if one token increases in value while the other decreases, you experience IL. Even if one token rises and the other stays the same, or if one drops and the other remains stable, you will still face IL.
To avoid impermanent loss, you ideally want the prices of both tokens to stay roughly the same or increase together.
How does Impermanent Loss Work?
Before we dive deeper, here are some key points about liquidity pools:
The product of the number of tokens A and tokens B remains constant (k).
The number of token A times its price equals the number of token B times its price.
(If these concepts are new to you, check out a basic guide on 'Liquidity Pools' for a simpler explanation.)
Impermanent loss can occur in several scenarios, which we’ll explore with examples:
- If one token’s price rises significantly.
- If one token’s price drops significantly.
- If the prices of both tokens move in opposite directions.
For instance, imagine you add Token A and Token B to a liquidity pool. If Token A's price skyrockets while Token B's price stays the same, you could experience impermanent loss. Similarly, if Token A's price plummets and Token B's price remains stable, or if Token A increases while Token B decreases, impermanent loss can occur.
How to avoid impermanent loss
Provide Liquidity with Stable Coin Pairs
One effective strategy is to invest in pairs of stable coins—cryptocurrencies tied to a fiat currency like USD or EUR. Since stable coins are designed to keep a steady value, typically around $1, they are less prone to significant price swings compared to other cryptocurrencies. For example, if you pair USD Coin (USDC) with Tether (USDT) in a liquidity pool, the risk of impermanent loss is minimized because both coins aim to maintain their $1 peg. However, it's crucial to keep an eye on the stability and reputation of the stable coins to ensure they remain pegged to their respective fiat currencies.
Provide Liquidity for Highly Correlated Pairs
Another approach to reduce impermanent loss is to invest in cryptocurrencies that are closely correlated. By selecting pairs that tend to move in tandem, your portfolio remains balanced even if their prices change. For example, pairing Ethereum (ETH) with Wrapped Ethereum (WETH) in a liquidity pool can help minimize impermanent loss, as their values typically move together. This strategy helps you avoid unexpected losses since the price movements of the paired assets are more synchronized.
Avoid Risky and Volatile Coins
Investing in volatile and risky coins increases the chance of significant impermanent loss. These coins can experience large price swings. To reduce this risk, avoid newly launched or low-liquidity tokens, which often lack stability. Instead, focus on more established and less volatile assets. For instance, sticking to well-known cryptocurrencies like Bitcoin (BTC) or Ethereum (ETH) can help minimize potential losses.
Provide when a coin price is low
Bear markets, where cryptocurrency prices are generally falling, can be a good time to provide liquidity. Prices are lower, which might help offset impermanent losses. By joining a liquidity pool during a bear market, you might benefit from price increases when the market recovers. For example, adding liquidity to a pool during a downturn can yield better results if the market later rebounds.
Take Advantage of Additional Incentives
Some platforms offer extra rewards for liquidity providers through liquidity mining programs. These programs give you additional tokens for staking your liquidity provider tokens. Participating in such programs can enhance your overall returns. For example, if you provide liquidity on a platform that rewards you with additional tokens, you can boost your earnings. However, always evaluate the risks associated with the platform and the tokens involved.
Explore Non-50/50 Liquidity Pools
Traditional liquidity pools usually require a 50/50 ratio of token allocation. However, some platforms allow for different weightings, such as 80% of one token and 20% of another. This flexibility lets you adjust the risk profile of your investment. For instance, if you believe Token A is more stable, you can allocate a higher percentage to it, thus potentially reducing impermanent loss
Wait for the Exchange Rate to Normalize
When you provide liquidity to a cryptocurrency pair, their market rates will fluctuate. The more these prices deviate from the rates at which you deposited, the greater your impermanent loss. To mitigate this, you can wait for the prices to return to their original rates before withdrawing your assets.
For example, if you added liquidity when Token A and Token B were both worth $10 each, you might wait until they return to these prices. However, due to the volatility of the cryptocurrency market, prices might not revert, and you could face a bigger loss.
One-Sided Staking Pools
Not all Automated Market Makers (AMMs) require two-currency liquidity pools. Some popular AMMs offer one-sided staking pools where you can provide just one type of currency, often a stablecoin. For instance, you might deposit USD Coin (USDC) into such a pool. In return, you earn a portion of the platform's accrued fees. Since you’re only providing one currency, there’s no price discrepancy between two assets, thus eliminating the risk of impermanent loss.
Consider Trading Fees
When providing liquidity, don't forget about trading fees. Traders who use liquidity pools must pay these fees, and as a liquidity provider, you receive a share of them. Sometimes, the fees can be substantial enough to offset any impermanent loss you've encountered.
For instance, if you provide liquidity to a popular pool with high trading activity, the collected fees might significantly reduce your impermanent loss. Therefore, it's beneficial to choose pools with a lot of trading activity to maximize your potential earnings and minimize losses.
