Impermanent Loss: A Comprehensive Guide
2 min read
Liquidity pools have been a game-changer in the world of decentralized finance (DeFi). Providing liquidity to an automated market maker (AMM) is a great way to earn passive income by earning a share of the trading fees generated by the AMM. However, as with any investment, there are risks involved, and impermanent loss is one of them. In this blog post, we will explain what impermanent loss is, what causes it, and how you can mitigate it.
What is Impermanent Loss?
Impermanent loss is the temporary loss of value that liquidity providers experience when they provide liquidity to an AMM. This loss occurs because the price of the two tokens in the liquidity pool can change over time, resulting in a temporary loss of value for the liquidity provider.
What Causes Impermanent Loss?
The reason why impermanent loss occurs is because the price of the two tokens in the liquidity pool can change over time. Usually, one token appreciates in value relative to the other, resulting in liquidity providers ending up with fewer tokens of the appreciating asset and more tokens of the depreciating asset. This leads to a temporary loss in value for the liquidity provider.
How to Mitigate Impermanent Loss?
One option is to provide liquidity to pairs where the price volatility is relatively low, so the risk of large price swings is reduced. By doing this, you can reduce the chances of experiencing impermanent loss.
Another approach is to go for those liquidity pools where the relative price change between the two tokens is low. One common example of this would be BNB-BNBx & MATIC-MaticX liquidity pools.
It's important to remember that impermanent loss is a temporary loss of value. If you hold onto your LP tokens for long enough, the price of the two tokens in the pool will eventually converge, and your loss will be recouped. Additionally, the trading fees earned by the AMM can help offset some of the impermanent loss.
In conclusion, impermanent loss is a risk that all liquidity providers must be aware of in DeFi. It's important to do your own research and never invest more than you can afford to lose. Providing liquidity to pairs with low volatility can help mitigate the risk of impermanent loss. By taking the necessary precautions, liquidity pools can still be a great way to earn passive income in the world of decentralized finance.