In today’s post, we’ll take a deep dive into impermanent loss, one major problem faced by AMMs.
No doubt, AMMs contribute largely to the success seen in DeFi.
Talk about a market size of $12.7 billion, nearly double what we had last year (2021).
However, the problem of impermanent loss seems to be discouraging investors.
If these terms sound like a lot, don’t worry I explained them later in the post.
Also, I explained how to reduce impermanent loss so that you can have a more profitable DeFi experience.
Are you ready? Let’s get to business.
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Brief Overview of AMMs
“AMMs” is short for Automated Market Makers.
It refers to a category of decentralized exchanges (DEXs) that replace the order book with a pricing algorithm.
In other words, the prices of assets are set automatically by a mathematical formula.
So, investors simply deposit their assets into liquidity pools at proportionate amounts.
Then they profit from transaction fees when traders buy tokens from those pools.
Needless to say, AMMs remove the need for middlemen in completing trades.
Also, any user can create a market for their assets thus, making AMMs hot cakes for DeFi products.
Popular AMMs include Bancor, Uniswap, Curve, Pancakeswap, and Balancer.
Furthermore, Liquid pools, Constant product formula, Slippage, and Impermanent loss are common characteristics of AMMs.
But our focus here is on Impermanent Loss so, let’s find out what it means in the next section.
Keep reading!
What Is Impermanent Loss (IL)?
Impermanent loss is simply an unexpected loss and it happens when the price of an asset changes after it has been deposited into an AMM pool.
Remember that AMMs operate with liquidity pools that contain token pairs in proportionate amounts.
Meaning that when the price of one token changes, the price ratio of the assets in a pool adjusts accordingly.
And it is expected that the price ratio will revert once the token regains its original price, removing the loss.
Hence, the reason it is called impermanent i.e. temporal.
However, two things can happen before the price ratio reverts:
- Investors (liquidity providers) may withdraw their funds to prevent further loss
- Arbitrage traders may leverage the opportunity to buy the token with a new price asset and sell it on another exchange thus reducing the amount of that token in the pool, much to the dissatisfaction of liquidity providers.
On the bright side, investors will not suffer impermanent loss if they are not in a hurry to withdraw their assets because liquidity pools are backed by smart contracts, and as such, the price ratio of the token pairs will eventually revert.
Look at a practical example of how impermanent loss occurs:
Say you deposited proportionate amounts of XRP and BUSD into an XRP–BUSD liquidity pool.
You can see on the AMM that the value of this pair is balanced.
But then, the price of XRP rises on exchanges.
And since DeFi apps are independent of external markets’ pricing, arbitrage traders may leverage market discrepancies to make profits.
So, they will buy XRP at a cheaper price from the XRP–BUSD pool and sell it at a higher price on other platforms.
Thus, creating a high demand for XRP, and further increasing its price.
With the increase in price, arbitrage traders may repeat the process until the pool prices balance.
In the end, arbitrage traders profit at your expense as you’ll own less XRP than you did before. Oops!
This is why investors may want to withdraw their funds at the slightest sign of impermanent loss.
Let’s talk about reducing this loss in the next section.
Tag along!
How To Reduce Impermanent loss
Although impermanent loss may seem inevitable in AMMs, these tips will help reduce its occurrence:
a. Go for stablecoin pairs
Most stablecoins are pegged to the U.S dollar at a 1:1 ratio.
So, they are not as volatile as other cryptocurrencies.
And as such, you’re saved from impermanent loss whenever there is a bear market.
However, the reward you receive from stablecoin pairs is low especially in bull markets.
USDT–BUSD and DAI–TUSD are some popular stablecoin pairs.
b. Invest in a single asset pool
These are pools where you only need to provide liquidity for one token.
Here, you are rewarded with a portion of the liquidation fees charged on the platform.
The profit may be low but so is the risk of IL.
Bancor Exchange has one-sided pools. You may want to check it out.
c. Choose flexible liquidity pools
Apart from single-asset pools, flexible liquidity pools are also a good choice.
That is, pools whose token ratio is not restricted to 50/50.
Token ratios may reach 60/40, 70/30, or even 95/5 in some decentralized exchanges.
Investing in such pools reduces the impact of impermanent loss because the pool must not balance the tokens at a 50:50 ratio.
So, the change in the price of one of the tokens may not create an avenue for loss.
You’ll find such pools in Curve and Balancer.
Also, Balancer allows you to provide liquidity for more than two tokens in one pool. Cool!
d. Trade with a small amount
This is noteworthy for all crypto investments especially if you are a first-timer.
When you trade on AMMs with a small amount you’ll experience less frequent losses in a sideways market.
A sideways market means there are no clear trends found in the market. Instead, prices are rising and falling, sometimes sharply, but not in any consistent direction. Sideways markets are typically volatile and indecisive.
https://www.indiainfoline.com/knowledge-center/derivatives/what-is-a-sideways-market
e. Trading fees can help
Usually, AMMs reward liquidity providers with a percentage of the fees collected from traders.
Sometimes, this reward may be sufficient to cover any impermanent losses.
f. Look before you leap
Before you provide liquidity to a particular crypto pair, first study the market.
If it looks like one of the tokens will outperform the other soon, don’t provide the liquidity.
On the other hand, if both tokens will likely rise or fall relative to each other, go ahead, since a change in any of their prices won’t affect much.
Truth is, some cryptocurrency pairs are less volatile than others, so providing liquidity to them can reduce your risk of impermanent loss.
g. Don’t be in a hurry to withdraw your funds
Remember that impermanent loss is temporal. Plus, cryptocurrencies are volatile and their prices are bound to change.
So, you may want to wait till the price ratio reverts before you withdraw your funds from a pool.
Heads up!!!
If you want to learn how to trade cryptocurrencies profitably, enroll in our Cryptocurrency Mastery Course by going to www.ctmastery.com.
You can also join our Telegram community at https://t.me/ctmastery for more information.
Conclusion
Trading on AMMs is highly profitable but impermanent loss can be a stumbling block.
Earlier, we discussed 7 ways to reduce impermanent loss including stablecoin pairs, one-sided pools, and low-volatility assets.
I hope this post was worth your time. Please drop any questions or suggestions you may have in the comments section.
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