Impermanent Loss: How to Lose Money When Providing Liquidity
By | Updated January 7th, 2022
What does Impermanent Loss mean?
Impermanent loss is a risk that comes when providing liquidity to a liquidity pool. Impermanent loss happens when your reward for providing liquidity is lower than if you had just held the coins in your wallet. In other words: You took your chances, and you lost.
Impermanent Loss explained
When you stake crypto, you earn a reward for helping to validate transactions on a blockchain. The only value the crypto platform gains from stacking is that it holds the stacked coin’s value. As such the person who staked the coin gets little reward for their contribution.
But naturally, that comes with low risk.
Stacking single assets carries less risk because it is not subject to impermanent loss – a danger unique to providing liquidity to a dual-asset liquidity pool.
Whereas the purpose of staking a token is to maintain its value, DeFi users provide liquidity in order to help other users trade in a timely fashion. In consideration of pooling two coins in a smart contract, liquidity providers receive a fee and possibly minted coins.
But a liquidity provider has to move their coins from somewhere before locking them in smart contract. And that is where impermanent loss gets its opportunity to occur: If the liquidity provider would have earned more money by simply HODLing their coins, they have suffered impermanent loss.
Impermanent loss doesn’t necessarily mean becoming poorer than when you started. A liquidity provider can certainly net a positive after an impermanent loss. They just won’t net as much as if they had HODL’d.
How Do You Avoid Impermanent Loss?
Sometimes impermanent loss is only avoidable if you HODL. But you don’t have a crystal ball, so how do you mitigate the risk of impermanent loss instead?
Look at the token’s price action. Are there wide fluctuations in the price, or does it mostly run sideways (“crabbing”)? Crabby charts are prime yield farming territory. (Not financial advice.)
Look for liquidity pools in which both stablecoins are pegged to the same asset. Because the two coins share the same asset, there can be very little volatility between them.
Stake instead. Impermanent loss results from market volatility, which doesn’t affect staked coins. The payout for helping to ensure protocol solvency may not be as great as with liquidity providing, but it comes without the risk of impermanent loss.
Impermanent loss is one of the risks that go hand in hand with liquidity providing. When the ratio which balances two assets in a liquidity pool is upset, the payoff for liquidity providing can become lower than the payoff for simply HODLing.
But suffering impermanent loss doesn’t necessarily mean losing money. It just means making less than you could have.