We've seen an increase in use of platforms like Uniswap, SushiSwap, and PancakeSwap as the popularity of Decentralized Finance (DeFi) platforms has grown. Anyone with money can become a market maker and collect trading commissions using these liquidity protocols.
However, there is one major flaw with Automated Market Maker (AMM) platforms: consumers who have liquidity risk losing their staked funds simply by retaining them.
In any case, the loss has a lower dollar value when withdrawn than when deposited.
Impermament Loss
One of the risks associated with Liquidity Pools in DeFi is impermanent losses.
The difference in value between funds kept in an AMM and funds held in your wallet is what this term refers to. When the value of the funds staked in the AMM fluctuates dramatically, it is called impermanent loss.
The greater the market volatility, the greater the chance of a temporary loss.
Because of the uncertainty in a trading pair, these price swings effectively result in a temporary loss of funds.
Institutional investors also seem to be scared away from supplying liquidity to liquidity pools due to the possibility of temporary loss.
What causes impermanent losses?
Since automated market maker platforms are decoupled from external markets, shifts in token prices on those markets have no effect on AMM prices.
Arbiters must buy the unpriced asset or sell the overpriced asset sold by the AMM for prices to change on AMM. Arbiters will churn out money as this is going on, resulting in a temporary loss.
So, what causes impermanent loss and how does it happen? Consider the following scenario.
Assume you have two forms of assets staked on an AMM (DAI/ETH pool). Traders would have an arbitrage opportunity if the value of ETH increases by 10%. Arbiters can buy ETH from the AMM for 10% less than they can on the open market. Arbiters would be rewarded if they sell equal DAI, thus balancing the AMM.
As a result, liquidity providers will experience a temporary loss from holding both ETH and DAI.
Why is it called "Impermanent Loss"?
The term "impermanent" means "temporary" or "not permanent." In other words, the loss of funds to the liquidity supplier is just temporary.
How do you get back on your feet after suffering an impermanent loss?
You will get your money back in one of two ways:
You will get your money back if the price of the token you staked in AMM returns to the original price (when you first staked your funds in AMM). If this occurs, you will have exited an impermanent loss and will be able to recoup 100% of your trading fees. However, this is a very unlikely occurrence, and you are more than likely to lose your funds forever.
How will impermanent losses be minimized?
Stablecoins are one way to cover yourself and mitigate your losses.
Liquidity Pools that provide liquidity through stablecoins that are locked in a smart contract are less volatile, reducing the risk of impermanent losses.
Joining pools of arbitrary weights is another way to reduce the chance of impermanent losses.
To mitigate the effect of impermanent losses, many liquidity pools allow users to deposit two assets in a 50/50, 80/20, or 98/2 ratio.
Final Thoughts
Before you dive into the world of DeFi, make sure you've done your homework and are aware of the dangers. Providing liquidity to a liquidity pool may be lucrative, but you must bear in mind the principle of impermanent loss.
