So simply, you can take a deep breath and wait for the prices to get to normal without withdrawing your crypto. However, this again will be a tricky job to do as the crypto market is volatile, but nonetheless, HODL. The user’s share is now 1.5 BNB and 40 CAKE, which equates to $100, but if this user held each asset individually, they would instead have $120. This is the impermanent loss in action, as arbitragers begin to buy CAKE with BNB, the pool shifts’ ratio, allowing the arbitragers to profit off the liquidity providers. Exchanges do this by first charging a fee for every swap and then sharing those fees as rewards with all liquidity providers in the pool.
However, in this case, since the weight of the BAL pool is 80%, we have less impermanent loss. Kyber Network is building a world where any token is usable anywhere. KyberSwap.com, our flagship Decentralized Exchange (DEX) aggregator and liquidity platform, provides the best rates for traders in DeFi and maximizes returns for https://www.xcritical.com/ liquidity providers. As price fluctuates and one asset outperforms another, you end up selling the more expensive asset for the “lagging” one. This acts as a portfolio that rebalances profits into the underperforming token. This rebalancing can be extremely powerful, considering how heavily correlated crypto assets are.
Impermanent Loss in Standard Pools
Even though we have more USDC than initially, the amount of ETH has decreased. The reason many find it difficult to spot impermanent loss isn’t because it is an inherent mystery – it is a calculable math problem. The team at Amberdata explained that due to its complexity, most resources only provide estimates. If you bought the token at a lower or higher price than it is currently, it would not allow you to change that.
The Impermanent loss is at least zero when the pool’s price is equal to when the LP provides liquidity. Firstly, with liquidity pools sellers don’t have to worry about connecting to other traders to trade at the same price as them. The algorithms in these pools automatically adjust to the value according to the platform’s exchange rate. Decentralized Finance (DeFi) has opened new opportunities for investors to earn interest on their crypto holdings through—Liquidity Pools (LP). However, just as there are two sides to every coin, liquidity pools can offer high-interest rates on one side and can sometimes lead to a downside risk called— Impermanent Loss. The key is weighing the opportunity costs of HODLing assets individually vs. LPing them to earn extra rewards at the expense of impermanent loss.
The 2 Cases of Impermanent Loss on V3:
However, while high interest rates are offered as a potential upside, liquidity pools offer a sometimes unknown downside risk known as impermanent loss. In the perfect world with no impermanent loss, the LPs would just be collecting money from trading fees. For example when it comes to Uniswap, each trade that goes through a liquidity pool pays a 0.3% fee that is proportionally distributed to the LPs of that pool.
Overall, IL is a crucial concept that all liquidity providers must understand. It is inevitable and will be present in all liquidity pools, besides https://www.xcritical.com/blog/what-is-liquidity-mining/ stablecoin pools with perfect correlation. IL is not a reason to avoid LPing; it is just a cost that comes with earning the additional rewards.
Can you avoid impermanent loss?
This is because they now hold less ETH when compared to their initial deposit. Sometimes, you might not lose your money, but the gains could be relatively less than expected. Suppose you have deposited an equal amount of ETH and DAI to an ETH-DAI liquidity pool on a Decentralized Exchange (DEX). Most of you in the DeFi space using liquidity pools must have encountered impermanent loss during the price movements. When providing liquidity, LPs can make a profit from fees, but you can still suffer a type of loss, which is impermanent loss. Keep in mind that liquidity pools around volatile assets are the most significant sources of IL risk.
- In many liquidity pools, IL is an unavoidable reality, but there are undoubtedly several strategies you can use to mitigate or even avoid the effects of IL entirely.
- In this article, we explain what Impermanent Loss is, and how it creates a risk to liquidity providers, and provide some solutions to mitigate this risk.
- The Auto.farm smart contract platform was created to automate the re-staking of popular farming pools to increase APY.
- However, because the protocol has automatically adjusted the amount of tokens held in the pool, you lost out on the CAKE rally.
- Alternatively, investors can utilize some of the more complex liquidity pools to mitigate the impact.
Crypto assets like ETH are not pegged to the value of an external asset like stablecoins, so their value fluctuates based on market demand. As an added complication, the risk and reward is different for every token pair depending on each one’s volatility. Exchange rates are set when buyers create demand and sellers offer supply. The order book matches the price a buyer is willing to pay with the price a seller is willing to accept. To estimate the IL, you should also calculate the value of the assets if you had just held them. The only way to overcome IL is to earn more in fees than you lose through IL.