Impermanent loss is one of the things you would come across when you are involved in a liquidity pool. The volatile nature of crypto assets makes it what to expect when putting tokens in pools.
All the parties involved in liquidity pools will likely face impermanent loss. Automated market marker (AMM) can help solve the mathematics in this regard.
In this post, we’ll learn about an impermanent loss in the crypto world. Before then, let’s understand the concept of liquidity pool and automated market marker (AMM).
What is a Liquidity Pool?
A liquidity pool is a digital pile of cryptocurrency locked in a smart contract. This results in creating liquidity for faster transactions.
Liquidity pools are designed to incentivize users of different crypto platforms, called liquidity providers (LPs). After a certain amount of time, LPs are rewarded with a fraction of fees and incentives, equivalent to the amount of liquidity they supplied, called liquidity provider tokens (LPTs). LP tokens can then be used in different ways on a Defi network.
The liquidity pool aims to eliminate the issues of illiquid markets by giving incentives to its users and providing liquidity for a share of trading fees.
A major component of liquidity is the automated market marker (AMM).
What is an Automated Market Marker (AMM)?
Automated market marker (AMM) is a protocol that uses liquidity pools to allow digital assets to be traded in an automated way rather than through a traditional market of buyers and sellers.
Users of an AMM platform supply liquidity pools with tokens and the price of the tokens in the pool is determined by a mathematical formula of the AMM itself.
AMM makes trades on DEX markets easy and reliable. They are programmed to facilitate trades efficiently by eliminating the gap between the buyers and sellers of crypto tokens.
What is Impermanent Loss in Cryptocurrency?
Impermanent loss is what happens when the price of your assets locked up in a liquidity pool changes. This creates an unrealized loss, versus if you had simply held the assets in your wallet.
In this case, a DEX allows any token holder to deposit their tokens into a liquidity pool. The token pair is usually Ethereum-based and a stablecoin like USDC. A transaction fee of 0.3%. will be paid to the liquidity providers.
A trader can therefore swap let’s say ETH for USDC in a liquidity pool. It has to be the equivalent amount of the token-a liquidity pool must contain a 50/50 ratio in the value of both tokens.
How does Impermanent Loss Occur?
Volatility is the major issue with cryptocurrency as prices can fall or rise at any time. The issue of volatility is what everyone involved in liquidity pools will face which will lead to impermanent loss.
Impermanent loss happens when the price of your token changes after you deposit it in the liquidity pool.
The loss incurred in this form is however for a moment-it is impermanent. If the Ethereum-based token later goes back down to the original price at your deposit, then you break even. Your loss is however permanent when you decide to withdraw after a price change.
How to Avoid Impermanent Loss in Cryptocurrency
1. Choose Stablecoin Pair that Offer the best
One strategy to avoid temporary loss is to choose stablecoins that offer the best bet against impermanent loss. This is because their value does not move much. They also have fewer arbitrage opportunities, lowering the risks. Liquidity providers using stablecoin pairs, on the other hand, are unable to gain from the bullish crypto market.
2. Choose Pairs that do not expose liquidity to market stability
You need to choose tokens (ETH based & stablecoin pair) that do not expose liquidity to market stability. Cryptos with an unstable history or high volatility should not be considered. Another strategy to avoid temporary loss is to search the market, which is highly volatile thoroughly.
Liquidity providers must also know when to sell their holdings before the price drifts too far from the starting rates. This would help to curtail the effect of a change in price.
4. Look beyond the loss
One of the best ways to overcome impermanent loss is to look beyond it. The tokens you’ve committed already have a purpose, which is to earn you trading fees. Let them do their job for the more you put into the equation.
Also Read- Understanding Crypto Security Tokens