Today’s topic is very important if you are getting into the Decentralized Finance (DeFi) space, especially if you are looking to join and liquidity pools, or yield farming. Impermanent Loss is something that if you don’t factor in, can wipe out the crypto you have provided up to a pool/farm leaving you down even just on the amount of crypto you can pull out.
For the usual disclosure, I am not a financial advisor, I don’t even work in finance at all. My day job is as a telecommunications software engineer. Treat everything you read here as some educational resources and not financial advise.
Impermanent Loss occurs when you have provided up a pair of cryptos into a yield farm or liquidity pool, and the value of one of the cryptos changes by greater percentages than the other crypto in the pair. Due to the way the pool wants to maintain balance of value between the two cryptos, arbitrageurs will buy/sell one of the cryptos for the other to change the ratios, in order to regain the balance.
When this happens, you could end up with less value in the pool than you put in., due to getting back less of one of the cryptos than you put in, causing you to lose the gains you would have otherwise obtained simply by holding the crypto yourself. I’ll go through an example below to help make this a little more clear.
The reason it is called Impermanent Loss is because it’s technically only a loss on paper, at least at the start. If the cryptos rebalance between themselves, the arbitrageurs will step in and rebalance, and the Impermanent Loss will go away. If you withdraw your funds from the pool/farm while an Impermanent Loss is in effect, that loss than becomes a Permanent Loss, and is no longer just a loss on paper, its a loss in your pocket.
The more volatile the price of the cryptos in the pool, especially if one of them is a stablecoin, the faster and more out of hand Impermanent Loss can be. These would also be the pools paying out the highest returns, because with everything in investing, crypto or otherwise, the greater the risk, the greater the reward. You also have to be careful about scams, as it would be quite easy to build a liquidity pool that would for sure hit Impermanent Loss, and the arbitrageur that rebalance the pool, can actually stand to make gains by purchasing one of the cryptos for below market value to bring the price up and balanced.
Ok, to try and make this a little more clear, because it can be a hard one to wrap your head around, lets take a nice example here. Let’s imagine a liquidity pool that has Tether (USDT) paired with Bitcoin (BTC). We are going to use very imaginary numbers for Bitcoin (BTC), to make the math easier. Let’s call the price of it $500, for a nice easy number to work with, that is close to the $1 price of our stablecoin. The pool is also setup to be 50/50 for both cryptos.
We are going to provide $20,000 worth of crypto to the pool. So we are providing up 10,000 Tether (USDT) at $1 a piece, and 20 Bitcoin (BTC) at $500 a piece. This gives us our 50/50 split value wise, and we have a balance between both going in.
Now, suddenly the price of Bitcoin (BTC) spikes up to $550. The arbitrageurs are now going to step in, and start buying the Bitcoin (BTC) that you have sitting there priced at $500, to bring the price in balance with the rest of the market. As they buy the Bitcoin (BTC) the market maker code that handles the pricing for the pool will start to bring things in line.
Using the formulas that the market maker software would, to get the price of Bitcoin (BTC) to $550 inside of the pool, we would need about 10,488.09 Tether (USDT) and about 19.07 Bitcoin (BTC). The arbitrageurs managed to buy 0.93 Bitcoin (BTC) for $488.09 Tether (USDT), which they could turn around and sell on the market for $511.50, giving them a profit of $23.41, minus any network and trading fees.
Now let’s look at how it affected you, providing the liquidity. When you put the funds in, you had a total of $20,000. Now when we crunch the numbers, you have $10,488.09 worth of Tether (USDT), and $10488.50 worth of Bitcoin (BTC) for a total of $20,976.59. If you had held both the cryptos instead, you would have $10,000 worth of Tether (USDT), and $11,000 worth of Bitcoin (BTC), for a total of $21,000, giving you a difference of $23.41, the same amount that the arbitrageurs profited from doing their deal.
That’s a pretty significant number when you factor in that we are only talking a 10% change in price, on a very low priced asset, since I’m using about 1/6th of the actual price of Bitcoin (BTC), and with recent price action, 10% can be a move you see within a day or two.
Using this chart that I have lifted from this medium article, about this same subject, We can see that if the price of one of the assets changes by 500%, that can give you an Impermanent Loss of 25%. That may seem like a stretch, but if you factor in the forecasts of Bitcoin (BTC) going from current market value of about $30,000, up to $100,000 and beyond, we are already talking about an over 300% increase. Impermanent Loss is no joke.
There are some actual benefits to providing liquidity, and these benefits may outweigh the risk to Impermanent Loss, but you have to do your own research on each of them you are considering, and factor in what you may gain from providing up your crypto, versus just holding it based on where you think the prices may go.
One of the benefits that a liquidity provider will get is part of the trading fees that go through the pool. Every trade that interacts with the pool, will generate fees, and those fees are split between the liquidity providers. These are generally not very much per transaction, but for a very active pool, they could add up quite quickly.
Then there is of course the returns you get from providing your liquidity. These are the returns you get from the pool, generally in the form of the native token of the platform. If you are looking at PancakeSwap, you get paid out in their PancakeSwap (CAKE) token. You of course need to factor in the price changes of that token when you consider the value you are getting out of the pool.
If the rewards you are getting back from the pool, is more than what you are losing out from Impermanent Loss, then the losses don’t matter, because you are still ending up ahead.
There is of course some things you can consider when looking at where to put your crypto to work for you, that can help mitigate the Impermanent Loss factor. Since crypto pools are a good one, because they don’t suffer from this. There are also some pools that are designed to have pairs that should maintain their value relative to each other, something the Curve Finance tries to accomplish by using pairs of stablecoins, or different versions of the same cryptos, like Bitcoin (BTC) and Wrapped Bitcoin (WBTC).
You can also look at a platform like Balancer, which uses pools that are not 50/50, and like a 80/20 or a 98/2 pool. In those instances, the higher the weight of the crypto, the less impactful Impermanent Loss is against it. And then there are even places like Bancor, which uses Oracle Services to monitor the prices from external sources, and automatically changes the weight of the pool, entirely mitigating Impermanent Loss.
Impermanent Loss is a tricky subject, but it’s vitally important to understand before you go throwing your funding into these opportunities. Yes, the returns can be juicy, but you can get rekt on the back end, so please, again, Do You Own Research for ANY project you are thinking of throwing your hard earned crypto into, and avoid losing out on your tasty gains. There are plenty of ways to earn those returns, just make sure your ass is covered.
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Want some more content right now? Check out some of my previous posts:
Average True Range (ATR)
Decentralized Finance (DeFi)
Non Fungible Tokens (NTFs)
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Originally Posted On My Website: https://ninjawingnut.xyz/2021/06/25/impermanent-loss/
