What are Impermanent Losses in DeFi?

The world of DeFi is certainly an exciting one, filled with new ideas and different ways to earn crypto revenue. Right now one may compare it to being in its “wild west” stage of evolution.

 

You won’t encounter John Wayne staring someone down while they gradually reach for their holster, but you will see many unique methods to make money. Decentralized exchanges (DEXs) like Uniswap provide a globally accessible liquidity protocol that anyone can participate in as a liquidity provider.

 

 

The establishment of liquidity pools might be DeFi’s most groundbreaking development yet. Users can take advantage of liquidity pools, such as Uniswap’s unauthorized automatic token exchange, to provide tokens (liquidity) for various projects.

 

DEXs like Uniswap and others that offer liquidity pools are known as Automated Market Makers (AMMs). AMMs are different from traditional crypto exchanges because they use a mathematical formula to calculate exchange rates instead of an order book.

 

When using AMMs, users may eventually encounter an “impermanent loss”.

 

 

Simply put, an impermanent loss is when a liquidity provider (LP) loses value in their crypto assets on an AMM. The LP then may start pacing around their room wondering, “why did I even provide liquidity to begin with?”

 

 

Knowing this risk has become a drawback to investing in DeFi liquidity pools for many investors. Unlike traditional passive income-generating financial services, AMMs constantly run the risk of underperforming a basic buy and hold strategy.

 

In this article we will cover…

 

1. Why are these losses “impermanent”?

2. How does impermanent loss occur?

3. What can limit impermanent losses?

Why are these losses “impermanent”?

Essentially, impermanent losses on AMMs are only temporary. Let’s say you provided liquidity using a UBXT/USDT pair in Uniswap and ended up suffering a loss. When the price balance of the UBXT you provided returns to its original value, the loss disappears and you’ll even earn some of the transaction fees as additional income.

 

Alright, so the loss isn’t permanent, so what’s the problem? The main issue with impermanent losses is that they can result in causing negative returns or consuming your capital over time.

 

 

Gradually losing your capital or seeing a big fat red negative balance on your account is enough to drive anyone bonkers.

 

 

 

How Does Impermanent Loss Occur?

Let’s break down how exactly an impermanent loss occurs in liquidity pools. To do this we’ll first need to dive into how AMM pricing works on DEXs like Uniswap and the role arbitrageurs play.

 

 

Due to their decentralized nature, AMMs are disconnected from centralized exchanges (CEX) such as Binance and FTX. While crypto prices vary according to the supply/demand balance on these exchanges, the pricing on AMM markets are not impacted by this force.

 

Arbitrageurs witness this as a financial opportunity and will come to sell overpriced assets or buy under-priced assets until the AMM prices match those on CEXs. The profits made by arbitrageurs are extracted from the pockets of liquidity providers, creating the impermanent loss.

 

This issue is one of the major cons in the widespread adoption of AMMs. Users do not want to sit there and continuously monitor and act on sudden changes on AMMs to avoid significant losses.

What Can Limit Impermanent Losses?

Have no fear, as the DeFi industry is aware of this issue and is making strides to combat it.

The first step in fixing this issue was realizing that by minimizing the difference in cryptocurrency prices on an AMM, the risk of impermanent loss is reduced.

By keeping the relative prices between cryptos in an AMM constant, liquidity providers have less risk and provide more confidence that swap fees will bring profits. By providing mirror assets into a liquidity pool, LPs can limit any potential impermanent losses.

Mirror assets are cryptos that maintain a fixed price ratio and are able to remain resistant against impermanent losses. Stable coins, such as DAI/USDC/USDT/TUSDT, are one such example of cryptos that can retain a consistent price ratio in AMMs.

Mirror assets draw a significant amount of liquidity thanks to their fixed prices. Since stable coins like DAI are fixed to the amount of $1, so they’ll be resistant to impermanent losses when provided as liquidity.

So the next time you wish to avoid impermanent losses in a liquidity pool, you may want to consider including a stable coin in the crypto pair you’re tossing in. USDT/UBXT, USDT/ETH, and DAI/ETH are a few great options.

Now that you have a better understanding of impermanent losses, would you still invest in liquidity pools? Tell us in the comments below!

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