Everything you need to know about impermanent loss in DeFi and how to avoid it, including how to balance it with possible rewards.
The Decentralized Finance (DeFi) revolution of 2020 introduced a new way to earn passive income through liquidity mining and other forms of yield farming. However, most users are still unsure whether DeFi provides better returns over the long term than the traditional buy and hold strategy, where your funds remain idle but may rise in value someday.
If you use the decentralized finance (DeFi) ecosystem, you have almost certainly heard the term “impermanent loss.” This concept is essential for anyone involved with DeFi to minimize investment risks. So what exactly is impermanent loss, and how can you avoid it in your portfolio?
How Do DeFi Platforms Work?
Before going into the specifics of impermanent loss, it is vital to understand how exchanges, liquidity pools, automated market makers (AMMs), and other essential components work together.
Unlike custodial exchanges such as Binance, which bear the cost of providing liquidity for traders, decentralized exchanges (DEXs) rely on aggregated funds referred to as liquidity pools to facilitate trades.
Liquidity pools come in pairs of tradable cryptocurrency assets, such as ETH-USDT, ETH-BUS, and ETH-DAI on decentralized exchanges (DEXs). They are designed to hold an equal value of their trading pairs, so if you deposit $200 worth of ETH in a pool, you will also need to deposit $200 worth of its asset pair to be a liquidity provider.
What is Impermanent Loss?
Impermanent loss refers to the reduction that occurs when the price of the assets you’ve deposited changes between deposit and withdrawal. If the difference is more extensive, you have a higher loss, and if less, a minor loss.
Liquidity significantly impacts asset prices, so it’s essential in traditional markets and decentralized finance (DeFi). Anyone who’s jumped on the DeFi bandwagon via staking knows the immediate risks of a liquidity pool.
Among them is impermanent loss, which comes from providing liquidity in DeFi. Although impermanent loss can be counteracted later, it’s still essential for investors to be familiar with it and understand how to avoid it.
How to Reduce or Eliminate Impermanent Loss
Earning passive rewards from trading commission fees can look like a surefire way to make your money work for you. However, impermanent loss is a possible outcome for which you should be prepared. The following are a few ways you might be able to work around impermanent loss.
Move with Caution: Plan to start with a small amount in liquidity mining until you learn how the market works or how impermanent loss can impact your plans.
Choose Stablecoin Asset Pools: Start with Stablecoin pairs like DAI-USDT, TUSD-DAI, and UST-USDC to avoid impermanent loss. These coins pegged to the U.S. dollar don’t fluctuate quite like other crypto assets.
Consider One-Sided Asset Pools: When selecting a pool for liquidity mining, consider one-sided asset pools that only require one token.
Opt for Uneven Liquidity Pools: Platforms such as Bancor and Balancer offer flexible pools that don’t require a 50/50 token ratio to finalize the accurate price of a supported asset. Some of them provide ratios like 80/20, 60/40, or other variations.
When investing in crypto assets, always plan your financial decisions based on your risk appetite. While there is some disagreement on the significance of the impermanent loss, it’s a phenomenon worth noting as you allocate your portfolio.
Tom is a freelance writer with over 10-years’ experience in content creation, blog writing, and SEO specializing in the blockchain and cryptocurrency niche. As a philosophical figurehead, he believes that to make our world a better place, we must invest in incorruptible products and procedures, of which Bitcoin and other cryptocurrencies are leading examples.