The DeFi room is always in motion and is constantly improving. Many new terminologies emerge as new concepts and applications are added. At the same time, people are constantly confronted with new terms that seem to appear in a new convention. From liquidity pools to staking and farming… many seem to be lost. With the growing popularity of DeFi platforms, more and more users are starting to delve deep into the crypto space. Automated market making (AMM) platforms like Uniswap were on the rise last summer and became one of the most popular platforms. However, there is a fundamental problem with this technology. This problem comes from the users who provide liquidity to AMMs, as they often lose their deployed tokens just because they keep them simple. In this article we will talk about what an impermanent loss is and how to mitigate the risk that comes with it.
What are liquidity pools?
Before we delve into what impermanent loss is, we need to explain what liquidity pools are. In the field of decentralized finance (DeFi), liquidity pools became famous for providing liquidity seekers … liquidity. For example, brokers that offer short selling often lend money to their traders before getting it back with instant profits. If the trading volume becomes very high, these brokers will need more liquidity, as they would expose themselves to great risk by taking on the risk of the other side. For this reason, liquidity pools were created. They basically pool the funds of crypto investors and pass them on to brokers, who in turn lend them to their traders. Once the traders have completed their trades, the brokers take back this amount plus a fee, then return the loan to the liquidity pools and also share the fees with them.
With Automatic Market Makers (AMM) like Uniswap, the broker (the middleman) is no longer involved. So, the liquidity providers directly finance the traders on an AMM platform and receive fees for holding their tokens in the liquidity pools. The difference between simple hodling and using it in liquidity pools is that in the latter case, you will receive passive income while your token will increase in value. With higher profits comes a higher risk, and here we are talking about the impermanent loss.
What is impermanent loss?
Simply put, the impermanent loss is the difference between owning your tokens in an AMM and owning your tokens in your wallet. As a rule, this happens when the price falls or rises within the AMM pool. The more the price falls or rises, the greater the impermanent loss. Note that it is called ”impermanent“ (”impermanent“), because if you do not dissolve your position, the loss is still ”unrealized”. To illustrate: imagine that you are trading an asset and its price begins to fall. Your broker would then show you your “unrealized P&L”, which in this case is a loss. The price of the asset could rise again and you could be in the plus again, but if you close your position, your loss will be “realized”, that is, “permanently”. When using liquidity pools, it is exactly the same, only it is called “inconstant” instead of “not realized”.
So, impermanent loss arises due to price fluctuations, in which the liquidity providers take the other side of the trade in an AMM environment against the traders.
How does AMM pricing work?
AMMs are decoupled from external markets, and this is an important point to understand. That is, if the price of a particular token changes on external markets, the price on the AMM will not be adjusted. In order for prices to change, a trader must come and buy the undervalued asset or sell the overvalued asset offered by the AMM. During this process, the trader takes the profits from the pools, resulting in an impermanent loss.
How to reduce the risk when using liquidity pools?
There are many ways to protect yourself when using it in liquidity pools. The first option is to participate in liquidity pools that contain stablecoins. Since the prices of stablecoins are fixed, this change in price will not occur, and inconstant losses will be avoided.
Another option is to participate in pools that offer a higher distribution model for the assets. Standard pools offer a 50:50 model, where users deposit 50% of one asset and 50% of the other. Other pools offer a higher ratio, such as 80:20 or even 96:4, which reduces the risk of a potentially risky or volatile asset.
One last way to mitigate volatile losses is to use the Bancor V2 pool, which helps the user to automatically adjust the weights to the external prices of the price oracles.
Conclusion
When there is a higher reward, there is often also a higher risk. Participating in liquidity pools is definitely a way to earn passively on DeFi, but users should be aware of the possible consequences. The recent Terra Luna story has shocked investors all over the world and caused them huge losses. That is why it is always advisable to invest only money that you can afford to lose. Always be prepared for the worst and do your own research on each investment, especially when participating in liquidity pools. Research the platform, the tokens, the history and check your willingness to take risks.
