Impermanent loss (also known as “non-permanent loss”), or loss of value due to providing liquidity to automated market makers (AMMs), is an inherent risk in providing liquidity in DeFi. Understanding how to navigate this phenomenon can enable liquidity providers (LPs) to better provide liquidity to AMMs. This article will outline a number of different strategies that will teach you how to reduce or avoid impermanent losses during DeFi activity.
What are Impermanent Losses?
The Decentralized Exchanges (DEXs) in the DeFi ecosystem pioneered the Automated Market Maker (AMM) model. AMMs are centered around liquidity pools that are driven by Liquidity Providers (LPs) who provide (deposit) cryptographic assets into these liquidity pools for anyone (traders) to trade through. What is the main idea behind this?
What is the main idea behind this? That is, traders can redeem the tokens they want through the liquidity pool at any time, and LPs are able to earn a portion of the transaction fees when the tokens in the liquidity pool are used.
However, for many liquidity pools, it is far from guaranteed that their LPs will be able to profit from transaction fees in a given time period. This is because of what is known as impermanent loss: due to the fundamental nature of how AMMs work and the volatility of cryptocurrencies, impermanent loss is a fundamental risk when providing assets to liquidity pools.
Simply put, AMMs like Uniswap use special algorithms to automatically maintain a balance of assets in a liquidity pool, such as maintaining a 50/50 ratio between the two asset values in the ETH/WBTC pool, and fluctuations in the prices of ETH and WBTC can cause a rebalancing of this ratio (rebalancings), in which case LPs suffer a loss of funds compared to their initial deposits.
This loss is also referred to as a “non-permanent” loss because it is only permanent if LPs withdraw liquidity at a time when they are in a constant state of loss. For example, due to market volatility, your LP position in a liquidity pool may experience an erratic loss today, only to have that erratic loss disappear again tomorrow, and so on.
What is the easiest way to understand anomalous losses?
Impermanent loss occurs when the value of LP positions is lower than the value of those deposited tokens on the open market. In other words, if you have more to gain by simply holding ETH and WBTC in your wallet than by depositing liquid assets into the ETH/WBTC pool on Uniswap, then an impermanent loss has occurred.
An example of impermanent loss
If you still can’t understand impermanent loss, here’s a simple example to help you understand.
Suppose you go to Uniswap and you want to provide $1000 liquidity in the ETH/USDC pool. If the current ETH price is $1,850 and the USDC price is $1, and since you need to put $500 liquidity in each of these two assets, this means you will end up depositing about 0.27 ETH and about 500 USDC into the pool.
Let’s then assume that after a few weeks, the price of ETH drops to $1400. At this point, rebalancing your LP position would leave you with 0.31 ETH and 434.96 USDC, for a total value of $869.92. By comparison, if you had simply held the initial 0.27 ETH and 500 USDC all along (instead of using them to provide liquidity to Uniswap), the total value of these two assets would have been $878.38, over $8.50 more than the $869.92. In this hypothetical example, the LP has suffered an impermanent loss of less than 1% ($8.50/$1,000 = 0.85%).
If you are interested in the Unconstant Loss calculation, consider using the Uniswap-centric Unconstant Loss Calculator tool from dailydef.org at
Screenshot source: dailydefi.org Unconstant Loss Calculator
Strategies to mitigate impermanent loss
Now that we know what impermanent loss is, how do we combat it? Impermanent loss is an inevitable reality in many liquidity pools, but there are certainly a range of strategies that can be used to mitigate or even avoid the impact of impermanent loss altogether.
Here are some of the most basic strategies to mitigate impermanent losses
- Avoid highly volatile liquidity pools
Cryptocurrency assets like ETH are not tied to the value of external assets like stablecoins are, so their value will fluctuate with market demand.
It’s important to note that liquidity pools centered on volatile assets are the greatest source of risk of impermanent loss. While crypto blue chips like ETH and WBTC may be more volatile, other smaller coins face a greater likelihood of intra-day price fluctuations, so they are more at risk from an impermanent loss perspective.
If avoiding impermanent losses is the most important aspect for you, then a wise choice would be to avoid providing liquidity to highly volatile liquidity pools.
- Choose liquidity pools that are anchored to the same asset
Stablecoins such as USDC and DAI are anchored to the value of the US dollar, so these are always trading around $1. Then there are other crypto assets that are anchored to the same asset, such as sETH and stETH for ETH, WBTC and renBTC for BTC, and so on.
In these liquidity pools anchored to the same asset (e.g. USDC/DAI pools), there is very little volatility between these tokens. This dynamic naturally results in little or no erratic losses for LPs. Therefore, if you want to become an LP and earn fees, but don’t want to face a lot of impermanent losses, then choosing to provide liquidity to these liquidity pools anchored to the same asset is a good option.
- Providing liquidity to pledge pools
In DeFi, not all LP opportunities come from dual token liquidity pools. In fact, other popular sources of revenue for LPs are staking pools, which are typically used to protect the solvency (in the event of insolvency) of DeFi agreements, and which only accept deposits of one type of asset.
For example, the Stability Pool of the lending protocol Liquidity: users contribute LUSD stablecoins to the Stability Pool to ensure the solvency of the Liquidity protocol in exchange for LPs receiving a share of the Liquidity protocol’s accumulated liquidation fees. A share of the proceeds. There is no impermanent loss in such a pledge pool because there is no rebalancing of the ratio between the two assets!
- Selecting a liquidity pool with unbalanced asset ratios
A liquidity pool with unbalanced asset ratios is one in which the asset value ratios are not traditionally split 50/50. Balancer is known for pioneering such flexible liquidity pools, where the asset ratios in a liquidity pool can be 95/5, 80/20, 60/40, etc.
These asset ratios can have an impact on impermanent losses. For example, in the case of an 80/20 based AAVE/ETH pool, if the price of AAVE rises relative to the price of ETH, then the impact of inconstant losses from price volatility is less than if the LPs in that pool provide the AAVE/ETH pool with 50/50 liquidity for the AAVE/ETH pool.
Thus, providing liquidity to such a liquidity pool with an unbalanced proportion of assets is also a way to mitigate impermanent losses, although it remains entirely dependent on the price performance of the underlying assets.
- Participate in the Liquidity Mining Program
Today, liquidity mining programs (i.e., protocols that distribute governance tokens to initial LPs) are ubiquitous in DeFi. Why? Because liquidity mining provides an easy way for these DeFi protocols to decentralize protocol governance, attract liquidity, and win the hearts and minds of early adopters.
However, there is another advantage to participating in liquidity mining, which is that in many cases, the token rewards earned by participating in liquidity mining can make up for any impermanent losses faced by LPs. In fact, if you earn token rewards equal to 25% – 100% of the value of your initial liquidity deposit over the course of two months by participating in liquidity mining, then the 5% capricious loss suffered during that time is worth nothing.
At the very least, these token rewards can offset the anomalous losses that LPs experience, so as an LP, you should always keep in mind the liquidity pools that provide incentives.
As AMMs grow in popularity, impermanent losses are a phenomenon that more and more people will have to deal with. The good news is that there are viable strategies that can help you do this competently and prudently.
Looking ahead, the recent launch of Uniswap V3 is at the forefront of the DeFi space with the introduction of ‘concentrated liquidity’, which allows LPs to provide liquidity in a specific price range, rather than having to accept liquidity across the entire price range (zero – positive infinity) as was previously the case. Concentrated liquidity” amplifies the gains and impermanent losses of LPs, so it is a new and more efficient LP model. As this concentrated liquidity model continues to be further adopted, expect to see more discussions on anomaly loss management!
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/five-strategies-to-teach-you-how-to-avoid-impermanent-losses-in-defi/
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