Impermanent Loss: What Does It Mean For Liquidity Providers?

• Impermanent loss is a temporary loss that occurs when you provide liquidity to a liquidity pool and your fund’s price changes compared to its original value.
• It is called impermanent loss because it only becomes permanent whenever you withdraw your funds from the liquidity pool.

Have you ever heard of liquidity pools? Well, these pools are offered by the platforms on which you deposit your funds and get interest in return. Providing liquidity to the pools often comes with a factor called impermanent loss. 

Impermanent Loss: What Does It Mean?

As the name suggests, an impermanent loss is a temporary loss that occurs when your investment or funds get unevenly changed due to how liquidity pools work. It is called an impermanent loss because it only becomes permanent when you withdraw coins from the liquidity pool. 

Let’s understand the concept with an example. Let’s say you deposit an equal amount of ETH and DAI in a 50:50 ratio. Liquidity pools generally require a 50:50 ratio to be deposited, as this secures accurate pricing. Now, let’s assume the price of ETH goes up on other exchanges. This will result in a procedure known as arbitrage. 

The traders will view arbitrage as a chance to quickly profit. As a result, they will buy the affordable ETH from the liquidity pool and trade it for more money on the exchanges. The process will take place until the price of ETH balances and becomes the same. 

Now, this will lead to traders making profits, but technically, liquidity providers will own less ETH as compared to their initial deposit. This net difference in the funds from the initial funds deposited is the impermanent loss that the liquidity providers face. Now, the main question is how to avoid it. 

How To Avoid Impermanent Loss

Well, you can try these few ways to avoid it and keep your funds in the liquidity pool: 

1. Choose Stablecoin Trading Pairs

To save your funds and lower your risk, you can choose the stablecoin asset pools, as they are less volatile in nature and do not see major price fluctuations. However, you have to watch out for stablecoins that might collapse. For example, Tether, a stablecoin, collapsed the previous year. 

2. Choose Pools Instead of a 50:50 Ratio

While many platforms require liquidity providers to deposit their funds in a 50:50 ratio. This equal share of tokens can put you at equal risk. Platforms such as Bancor and Balancer offer flexible liquidity pools where you can customize the ratio in your own way. 

3. Avoid Volatile Crypto coins

If you choose a volatile coin, you will increase your chances of suffering a temporary loss. While Stablecoins often see minor price fluctuations, other cryptocoins can see huge changes in price. This can increase your chances of getting your funds changed. The bigger the change, the higher your chances of having an impermanent loss. 

These are all the ways in which you can avoid the loss and save your funds in the liquidity pool. The concept of impermanent losses was a bit misleading, as you are able to compensate for these losses with the fees you earn from the liquidity pools. Also, as stated earlier, it is not permanent in nature until you withdraw your funds.