In the world of decentralized finance (DeFi), impermanent loss is a risk to be aware of before providing liquidity to protocols. What are the measures to take to protect yourself as effectively as possible?
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What is impermanent loss?
The impermanent loss (or impermanent loss in French) is a phenomenon that can occur in decentralized finance (Challenge) when the value of a cryptocurrency in a liquidity pool changes.
In DeFi, liquidity pools are pools of cryptos that are provided by users to facilitate trading on a decentralized exchange (DEX). As the value of liquidity pool tokens may change over time, there is a risk that the value of tokens provided by a user will decreaseresulting in what is known as the impermanent loss.
Despite this risk, individuals who provide liquidity to trading pairs are compensated by fees paid by other users when trading the relevant tokens.
Here’s how impermanent loss works. Imagine that a liquidity provider adds equal amounts of ETH and USDC to a pool, but the price of ETH suddenly increases. Other DEX users will then be able to take advantage of an arbitrage opportunity, as the price of ETH in the liquidity pool does not match the market price. Traders will then buy ETH at a reduced price until the balance of tokens in the pool is restored.
After this arbitrage session, an individual who provided liquidity to the pool could then end up with more USDC and less ETH. If he withdraws his cash at this time, he will realize a loss. This loss being the difference between the new amount of the user’s assets and the amount he would have had if he had kept his cash in the pool.
It is this decrease in value that is known as impermanent loss. (impermanent loss).
It is called “impermanent” because the loss is not permanent. This is because if the value of the assets in the liquidity pool were to increase again, the losses of the liquidity provider would be recovered. However, there is still a risk of loss if the value of the cryptocurrencies in the liquidity pool does not increase.
The impermanent loss is a risk present in any pool of liquiditybut it is particularly significant in the context of DeFi because DEXs are often used to trade a wide variety of cryptocurrencies, which can have very different values.
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There are several ways to avoid impermanent loss in decentralized finance (DeFi).
Monitor the value of assets in the liquidity pool
By carefully monitoring the evolution of the value of tokens in the liquidity pool, it helps to be more vigilant about changes that may affect its positions. This can help them make informed decisions about when to adjust their positions, which can help minimize their risk of loss.
Use liquidity pool insurance
Some DeFi protocols offer liquidity pool insurance, which can help protect users against losses due to impermanent loss and other risks. By using this type of insurance, users can reduce their risk of loss and gain peace of mind.
Diversify your assets
One way to reduce the risk of impermanent loss is to diversify its assets in the liquidity pool. By holding a mix of different tokens, it reduces the impact of variations in the value of a single token.
Have a well-honed and wise strategy
It is possible to use a specific trading strategy to avoid the impermanent loss. For example, a user can decide to only provide liquidity for tokens that are less likely to experience significant changes in valuesuch as stablecoins, or frequently adjust positions to minimize its risk of loss.
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In conclusion on the impermanent loss
Overall, the best way to avoid impermanent losses is monitor your positions carefully and take precautions to minimize your risk of loss, including avoiding little-known tokens with low liquidity. By doing so, you are more likely to preserve your capital and generate returns with confidence with DeFi.
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Editor-in-chief of Cryptoast, I discovered Bitcoin and blockchain technology in 2017. Since then, I have been striving to share quality content so that the sector becomes more democratic for everyone.
Clement Wardzala
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