How to Avoid Impermanent Loss When Providing Liquidity in DeFi

This calculator breaks down the annual percentage yield across different timeframes for a given principal (in $) and APY percentage to help estimate earnings. BitDegree Crypto Reviews aim to research, uncover & simplify everything about the latest crypto services. Easily discover all details about cryptocurrencies, best crypto exchanges & wallets in one place. Read fact-based BitDegree crypto reviews, tutorials & comparisons – make an informed decision by choosing only the most secure & trustful crypto companies. To ensure that the ratio of USDC to ETH remains balanced, other traders buy ETH at a discounted price until equilibrium is restored.

The loss being a reduction in value of your staked A and B tokens from the point of deposit to when you withdraw. Impermanent loss refers to the potential loss of assets as the result of a staked token price rising or falling after you deposit it in a liquidity pool. With ETH still at a value of $1,300 USD but AAVE now at a value of $10 USD, this would have a combined value of $1050 USD. If Bob had not participated in the liquidity pool and had just held his 1 ETH and 20 AAVE, he would have assets to the value of $1,500 USD. As this is higher than what he could currently withdraw from the liquidity pool, it is termed an ‘impermanent loss’. If Bob chooses to withdraw his assets at this loss, it changes from an impermanent loss to a permanent loss.

• As outlined earlier, certain liquidity pools are more subject to impermanent loss than others.
• Impermanent loss is the net difference between the value of two cryptocurrency assets in a liquidity pool-based AMM.
• If you were using $2000 of both tokens, which is double the example, your impermanent loss would be $171.58.
• For any investor, it is essential to be aware of the related risks concerning decentralized finance, better known as Defi.
• In the “future prices” section, the value of Token A, has increased to $200 while Token B, has remained at $1.
• Committing assets to liquidity pools composed of less volatile assets reduces the likelihood of significant price movements, minimizing the impact of impermanent loss.
• In volatile conditions, however, the fees alone are unlikely to cover the difference, especially during a bull run.

Effectively, this means that a transaction’s gas fees might spike significantly in the interval between the transaction being submitted and validated. Consequently, such a transaction might not be accepted by the chain, but the gas fees are taken anyway, potentially leading to financial loss for the user. Using Uniswap’s constant product formula, we calculate your impermanent loss and help you plan investments more efficiently. These fees can beat the impermanent losses you may face when you withdraw tokens.

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While impermanent losses can represent significant value, the scenario outlined above does not take into account the trading fees an investor earns by committing assets to a liquidity pool. In some cases, trading fees paid to liquidity providers can negate impermanent losses and generate profit for investors regardless of asset ratio changes. For example, Bancor aims to mitigate impermanent loss by adjusting weights based on external prices from price oracles. As a result, the protocol can eliminate impermanent loss in even the most volatile assets. And Tokemak uses single-sided liquidity pools where the protocol’s native token absorbs the risk of impermanent loss in exchange for swap fees and bribe rewards. Bancor is another platform that has implemented oracles with its liquidity pools to help minimize impermanent loss.

The concept of impermanent loss, though new, is not strange to investors in the decentralized finance ecosystem. The process of providing liquidity, and the resultant LP tokens and their properties are a grey area in most tax jurisdictions. Impermanent loss is a challenging concept, but it boils down to the opportunity cost of using liquidity pools.

Have you ever noticed that the amount of tokens you’ve provided to a liquidity pool have been reduced over time? After arbitrage, a liquidity provider may end up with a greater amount of UDSC and slightly less ETH. Impairment loss is the difference between the trader’s new portfolio balance and what they would have had if they had just held on to their old balance. The loss is realized when a trader withdraws the liquidity from the pool. In this case, Alice’s loss wasn’t that substantial as the initial deposit was a relatively small amount. She made some nice profits since her deposit of tokens worth 200 USD, right?

When depositing into a pool, you must also put an equal amount in value for both tokens. Then, if the entire pool contains 10 ETH and 1000 DAI after your deposit, your total share is 10%. While liquidity remains constant in the pool , the ratio of the assets in it changes.

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But bear in mind that the loss may only be temporary and that you may have earned a good amount from the trading fees. In many cases, the fees generated by a liquidity pool are of sufficient value to offset and mitigate impermanent losses. The impact of impermanent losses decreases in proportion to the increase of trading fees within a pool. Depending on the price fluctuations of the assets you staked, you may have slightly less of one of the assets depending on the market prices at the time.

Well, it’s a thing called impermanent loss, and everyone who plans on providing liquidity in liquidity pools needs to understand it. One popular method to earn with crypto is what’s known as liquidity providing or (LP.) Liquidity providers can earn trading fees by becoming what is known as an automated market maker or AMM. Impermanent loss is a the fundamental concepts that should be fully understood by anyone who wants to provide liquidity to the Sovryn protocol.

Impermanent loss is a risk that can occur when trading on DeFi platforms that use AMMs. It is caused by the difference in price between the time a trade is executed and the time it is settled, and can result in a loss for the trader even if the trade was otherwise successful. DeFi not only creates new investment opportunities for crypto holders but also presents unique challenges.

Impermanent Loss

If the trading volume is high, it can be very profitable to provide liquidity. For some tokens, external incentives are offered to provide liquidity to specific pools. But this should always be judged against the risk of impermanent loss if the price of one of the two assets deviates significantly from the other. Liquidity pools are automated programs where users deposit cryptocurrency in exchange for fees generated when others trade or borrow with their liquidity. If you have a crypto wallet, you can add funds to a liquidity pool and collect token rewards. You’ll often find liquidity pools on DeFi applications like DEXs and decentralized lending platforms.

Wrapped cryptocurrencies are used to transfer non-native tokens to alternative blockchains. The value of a wrapped crypto should always be the same as the https://xcritical.com/ underlying asset. Although the price of ETH is more volatile than a stablecoin, an ETH-wETH pair should be worth the same market price at all times.

How to hedge impermanent loss

So if you would’ve held your assets, your total profit would’ve been $1300 ($800+$500). You would have made $100 more if you did not participate in the liquidity pool. Impermanent loss is the value difference between two scenarios – simply holding tokens, and depositing tokens in an AMM’s liquidity pool. It occurs when your deposited tokens are lower in value when withdrawing from the liquidity pool than when you were just holding the tokens.

It’s important to note that large price movements in the price of the assets that make up a liquidity pool can increase impermanent loss. This is not an actual loss because the loss is based on the value of your investment if the tokens were held outside of the liquidity pool definition liquidity pool. Therefore, if you measure your cash investment, the temporary loss may not result in losing money. Liquidity pools often have two assets, and if one can be a stable currency like DAI, the other can be a more volatile cryptocurrency like ETH.

What are liquidity pools?

The loss is considered “impermanent” because if the price between the assets were to return to that at the time of the original liquidity contribution, the loss would be reversed. There are, however, a number of factors that can mitigate the impact of impermanent loss. If you decide to withdrawal your original position of equal parts USDC and ETH , you will likely get slightly less ETH than you originally deposited given it was traded at a higher volume. Tokenbase is a holistic database for the analysis of tokens and combines our identification and classification data with market and blockchain data from external providers.

You could argue that impermanent loss is the risk that liquidity providers take in exchange for fees earned by trading crypto pairs on liquidity pools. If the loss is greater than the fees earned, the liquidity provider realizes a loss, which might not have happened had they held onto their tokens instead. It is interesting to note that you might not actually lose money, but your gains might be less than if you had just held the tokens.

One-sided liquidity pools

Here you can manually set your deposit amount as well as the ratio of the pool, the pool weight. Impermanent loss can also be minimized by setting up a portfolio of assets that are relatively well-correlated. This way, when the prices of the assets diverge, the portfolio will remain relatively balanced, and the trader can avoid any unexpected losses. If you’ve been involved with DeFi at all, you almost certainly heard this term thrown around. Impermanent loss happens when the price of your tokens changes compared to when you deposited them in the pool.

However, impermanent losses depend on each protocol’s specific rules and you’ll need to research the algorithm used by your DeFi protocol to make the most accurate calculations. For example, when depositing a cryptocurrency into Uniswap, the protocol will mint and send you a liquidity token, representing your contribution to the liquidity pool. Then, whenever a trade occurs, the sender pays a 0.3% fee distributed pro-rata to all liquidity providers in the pool – providing you with a source of income. If we decide to withdraw our funds, we are still entitled to a 10% share of the pool. As a result, we can now withdraw 0.5 of token “A” and 200 of token “B”, totaling $400. As you can see, we made a decent profit since our initial deposit of $200 worth of tokens, but what if we simply held our 1 token “A” and 100 token “B”?

A program called an automated market maker adjusts the price of the tokens in the pool in response to supply and demand. Impermanent loss is the difference between what your value would have been if you had held your crypto assets and the value of assets you put into a liquidity pool instead. If the value would have been higher if you just held your crypto in your wallet rather than providing liquidity, then you have an impermanent loss. Credit to BalancerIt is worth noting the 50/50 pools are much more common than others, especially on Uniswap. Since trading fees go to liquidity pools, your yield is determined by how many people are using your liquidity pool.